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COPYRIGHT DEPOSrC 



ECONOMICS 
FOR THE ACCOUNTANT 



ECONOMICS 
FOR THE ACCOUNTANT 



BY 

KEMPER SIMPSON, Ph.D. 

FOHMERLT LECTURER IN THE JOHNS HOPKINS UNIVEHSITT 
AND ECONOMIST IN THE FEDERAL TRADE COMMISSION 




D. APPLETON AND COMPANY 

NEW YORK LONDON 

1921 



^^1 



1 

^ rr' U 



COPTRIGHT, 1921, BY 

D. APPLETON & COMPANY 



NOV 26 1921 



0)CI.A527884 



PRINTED IN THE UNITED STATES OF AMERICA 



•vvO \ 



PREFACE 

In these days any text-book in the social sciences or 
on the principles of business needs an apology. The 
student with equipment who has the time and opportunity 
to attempt to contribute to his science should hesitate 
before burdening the press with another text. I paused, 
therefore, before adding another text on the subject of 
economics, but after much deliberation decided that there 
was a definite ne'ed for a specialized analysis of economic 
theory for the accountant. 

The economist and the accountant deal with substan- 
tially the same facts, even though they have different per- 
spectives and somewhat different purposes. The economist 
is usually a dispassionate philosopher who looks on man 's 
economic activities for the purpose of studying and ex- 
plaining them. The accountant is working in the midst 
of business organization and is gathering and classifying 
facts for his employer. If he would do his work intel- 
ligently, he must have some understanding of the economic 
system in which his employer is functioning. There are 
many problems of interest to the economist that have only 
an indirect relation to the accountant's work. For this 
reason the ordinary text-books on economic theory include 
lengthy discussions on many phases of economics in 
which the accountant is not interested and give insuffi- 
cient treatment to what he would consider more funda- 
mental problems. It might be supposed that some of the 
more "practical" economic texts, such as are used in the 
business schools, might give the accountant what he needs. 
These so-called practical texts, however, usually collect 



vi PREFACE 

and schematize certain useful facts that are mere com- 
monplaces to the practical accountant. Moreover, it will 
soon be discovered that it is the most abstract and subtle 
economic reasoning that underlies the principles of ac- 
counting. 

When this work was first being planned, it was sug- 
gested to me that there is need of an exposition of ac- 
counting for the economist. This book should also be 
of use to the economist who is interested in the theory 
of accounting. Moreover, any economist who gives con- 
sistent thought to accounting will find much of purely 
theoretical economic interest in the subject. He will find 
that he must be more careful in defining .capital, interest, 
and profit and that he will have to make some important 
distinctions between the different kinds of cost. I feel 
that through my contact with accounting principles I 
have been able to present certain more or less important 
contributions to economic theory. 

The student who expects to get the most out of this 
book should know something about accounting, and if 
he knows anything about accounting, he will necessarily 
have some grasp of the fundamentals of economics. In 
short, this book was not written primarily for the ele- 
mentary accounting student although, in the absence of 
any other text of this kind, it could be used even by 
students of elementary accounting, if supplemented by 
classroom lectures. 

There is one word in regard to the scientific method 
to be employed in the two studies, and especially in 
accounting. The economist 's first problem is to determine 
"what is"; a description of "what ought to be" may 
follow, but it should be predicated on a knowledge of 
"what is." The economist may use his science for con- 
structing methods of improving the welfare of society, 



PREFACE vii 

but he thereupon becomes a reformer or even a propa- 
gandist. It is not contended here that an economist 
should not at times be a reformer or a propagandist, but 
it is believed that he should be careful to obtain the facts 
first. The accountant probably needs more warning on 
this score than the economist. The accountant may work 
for a producer or for a public body, but he should never 
change his definitions or adopt a revised set of principles. 
The concept of ''cost" should never be changed so as to 
serve as a weapon for enforcing good financial policy or 
for effecting social reform; the accountant's definitions 
should be carefully thought out and rigorously adhered 
to. It is no sound argument against the principle in- 
volved in the inclusion of interest in cost that the applica- 
tion thereof would tend to inflate cost and allow the 
producers greater profits than they would otherwise en- 
joy. The amount of depreciation the accountant should 
charge should not be affected by the financial condition 
of the company or by the wishes of its directors. The 
accountant should tell the truth as he sees it and should 
be careful not to revise his classifications for some special 
purpose, no matter how justifiable the particular cause 
may seem to be. 

The problem of interest as a part of cost is so much 
disputed, and the light that economic theory can throw 
on the discussion is so considerable, that a special appendix 
is devoted to the subject. The problem is discussed in 
Chapter X as well as in other chapters, but an entirely 
satisfactory discussion of this question was not possible 
until all the principles outlined in Chapters X and XI 
were set forth. Before this problem can be understood 
by the accountant, he must establish firmly certain careful 
definitions of the entrepreneur, the capitalist, capital, 
capital goods, cost, interest, and profit. Certain other 



viii PREFACE 

disputed items, which might have been discussed in 
Chapter X, were reserved for Appendix II because of 
their technical accounting interest and because it was 
difficult to treat them until all the general principles had 
been set forth. 

Kemper Simpson 



CONTENTS 

PAGE 

Preface v 

CHAPTER 

I. Economics and Accounting 1 

The Development of Accounting 1 

The Development of Economics 3 

The Economist's Point of View 4 

The Accountant's Point of View 5 

II. The Accountant's Problems 8 

The Balance Sheet 8 

The Profit and Loss Account 12 

The Cost Statement 13 

III. Consumption and Production 18 

The Definition of Economics and Its Subdivisions. . 18 

Production 19 

Labor 21 

Land 22 

Capital Goods 23 

Capital 24 

The Entrepreneur 26 

The Division of Labor, Distribution, and Exchange . . 31 

Another Definition of Economics 32 

IV. Distribution .. ■. 34 

Distribution and Marketing 34 

The Productivity Theory of Distribution 36 

Wages 39 

Interest 43 

Profit 45 

V. The Economist's Problem 47 

The Meaning of Economics 47 

ix 



X CONTENTS 

CHAPTEH PAGB 

The Study of Prices 50 

Practical Economics 51 

VI. Price and Demand 54 

Price 54 

Marginal Utility 56 

Marginal Utility, Cost, and Price 60 

Artificial Stimulation of Demand 64 

VII. Price and the Medium of Exchange 54 

The Marginal Utility of Money 64 

The Standard of Value and the Medium of Exchange 66 

Paper Money 68 

The Quantity Theory of Money 69 

Price Indices 71 

The Economic Evils of Changing Price Levels 74 

VIII. Economic Cost and Accounting Cost 77 

Economic Costs 77 

Money Costs 80 

Accounting Costs and Entrepreneur's Cost 81 

IX. The Elements op Accounting Cost 86 

Raw Materials 87 

Wages 91 

Overhead 92 

Joint Costs 94 

X. The Doubtful Elementsi of Accounting Cost 105 

Interest in Cost 106 

Rent as a Cost Item 108 

Depreciation as a Cost Item 110 

XI. Capital,, Capital Goods^ and Investment 113 

Uses of Capital 113 

The Need for Determining Capital 114 

The Balance Sheet 116 



CONTENTS XI 

CHAPTER PAGE 

The Valuation of Capital Goods 119 

Goodwill 124 

The Basis of the Interest Charge 128 

XII. Price, Profit, and Cost 136 

Profit and Entrepreneur 136 

The Pure Entrepreneur 137 

Functions of the Entrepreneur 139 

The Risk Theory of Profit 140 

The Reason for Profit 142 

Principal Kinds of Profit 145 

The Relation between Price and Cost 147 

XIII. Competition 152 

The Assumptions of Competition 152 

Collective Bargaining 154 

Price Control 155 

Large Scale Production 157 

Unfair Competition and the Anti-Trust Legislation. . 161 

XIV. Taxation 165 

Man's Political Relations 165 

The Purposes of Taxation 166 

The Single Tax 167 

The Shifting and Incidence of Taxation 169 

The Income and Profit Taxes 170 



APPENDICES 

I. Interest as a Part of Cost 177 

II. Cash Discounts on Sales, Bad Debts, Outward 

Freight, Donations, and Taxes on Profits 190 

III. Questions in Economics for C. P. A. Examinations 198 
Index 203 



ECONOMICS 
FOR THE ACCOUNTANT 

CHAPTER I 

ECONOMICS AND ACCOUNTING 

The Development of Accounting. — Since the Civil 
War business organization has become increasingly 
complex. Business units have become larger and are 
not so readily interpreted by simple methods of book- 
keeping. Although new fields of industry are con- 
stantly being invaded, competition in many lines is 
becoming keener and keener. The complexity of 
business organization has been responsible for the 
replacement of the bookkeeper by the modern 
auditor, and the keenness of competition, along with 
other factors, has developed the field of the cost 
accountant.^ The World War too, through the neces- 
sity of price fixing and taxation (especially the 
income and excess profits taxes), has made it neces- 
sary for all business to give some consideration to 
the problems of accounting. 

Although modern accounting has developed from 
bookkeeping, the modern accountant must have a 

* The cost accountant establishes the price below which it would be 
unprofitable to sell, 

1 



2 ECONOMICS FOR THE ACCOUNTANT 

much larger equipment than the old-fashioned book- 
keeper. As business organizations have grown larger 
and more complex, the producer has been less able 
to grasp all the facts of his business and has come 
to depend upon the accountant more and more for 
a summarization of details. Furthermore, the ac- 
countant has developed from a mere keeper of 
records (that is, a bookkeeper) into an interpreter 
of those records. The producer relies on his ac- 
countants for all those facts that he needs in deter- 
mining his business policies. But it must be remem- 
bered that the producer is not working alone; he is 
functioning in a complex economic organization, and 
it is the accountant's business to understand the 
economic relations of his employer. If the ac- 
countants do not understand the system in which the 
producer functions, of what use to him will their 
presentation of facts be? In short, accounting is 
merely a combination of scientific bookkeeping and 
economics.^ 

In order to comprehend the differences between 
the functions and the purposes of the accountant and 
the economist, it will be necessary to consider the 
way in which accountancy and economics first at- 
tracted the attention of mankind. As early as there 
was business there was some kind of bookkeeping, 
but it was not until business became complex that 
the principles of accounting were formulated and it 
was not until competition became keen that cost ac- 
counting and auditing (as it is understood to-day) 

' Economics includes corporation finance, taxation, etc., as well as 
pure economic theory. 



ECONOMICS AND ACCOUNTING 3 

began to claim so much attention. Accounting, then, 
has become a science since the '80s. 

The Development of Economics. — ^Economics, or 
political economy, has had a respectable position 
among the sciences ever since the Eevolutionary 
War and its principles have been more or less heeded 
by governments since the Napoleonic Wars. Political 
economy descended from two very unlike parents; 
the finance minister of kings and the academic 
philosopher. The problems of taxation and money 
early interested the monarchs of Europe and their 
ministers of finance. The kings of France thought 
of the people merely as taxpayers who supplied them 
with the means for lavish expenditures, but Quesnay 
warned them that a rich people make a rich country 
and a rich king. The other parent of political 
economy was the professor of philosophy, who 
stopped to consider man in his economic as well as 
his ethical and political relations. Francis Hutche- 
son and Adam Smith gave political economy an 
academic position, which stimulated the keenest 
scientific minds to give it attention. 

Adam Smith's book was called the Wealth of 
Nations, but would probably have been called 
Political Economy had not another book by Sir 
James Stewart with that title appeared a few years 
before. To-day, ' ' economics ' ' is probably more com- 
mon than "political economy," but the older term is 
significant in that it shows that it was the effect of 
the state on the economic relations of man and on 
the wealth of nations that was of particular interest 
to the economist. Economics in England and in the 



4 ECONOMICS FOR THE ACCOUNTANT 

United States, to-day, lays less stress than formerly 
on the state and more on the consumers and laborers 
as classes. It is a fact of some interest that just 
before the War a German economist of distinction 
remarked that there were very few American econo- 
mists who gave sufficient attention to the state in 
their studies, and that there were few American 
political economists for that reason. It was char- 
acteristic of German economics and of German gov- 
ernment that the importance of the state was always 
emphasized. In England and the United States, a 
policy of laissez-faire allowed men to develop 
economic organizations with the least possible gov- 
ernmental interference. The protectionism, govern- 
ment ownership, and taxation of Germany were 
consistent with German political economy, whereas 
English free trade, private ownership, and taxation 
cannot be dissociated from English economics.^ 

The Economist's Point of View. — ^Although the 
economists of to-day may be less interested in the 
state than were the early political economists, they 
have always retained their interest in society. It is 
society as consumer and society as producer that the 
economist considers. No individual or no one group 
of individuals should occupy the economist's entire 
attention or receive special treatment. He may work 
for one or the other of these groups, for example, 
laborers, entrepreneurs, etc.,* but, then, he becomes 

'Protectionism in the United States is erplained by the necessity 
of helping certain industries to get on their feet, whereas German 
protectionism was a governmental policy designed to make Germany 
a self-sufficing political unit. 

*See Chapter III, page 26. 



ECONOMICS AND ACCOUNTING 5 

a propagandist and is in danger of losing his impar- 
tial scientific attitude. The economist describes and 
attempts to show causal relations, but he should be 
careful whenever he introduces ethics and talks of 
what "ought to be" rather than of what *4s." It 
is, to say the least, practical to determine what "is" 
before deciding what "ought be be." 

The Accountant's Point of View. — The accountant 
is the producer's (entrepreneur's) bookkeeper, 
grown philosopher.^ Even the public accountant 
does most of his work for the entrepreneur. He 
analyzes the activities of the producer's business, and 
only incidentally considers those of society as a 
whole. While he sets up his accounts, he always has 
in mind that they are being prepared for his em- 
ployer: he is concerned with the laborers merely be- 
cause they receive wages, which he must include in 
his employer's costs or expenses. The consumers, 
for whom it will be shown all production is carried 
on, claim the accountant's attention only because 
they pay the producer prices, which constitute the 
"Sales" of the accountant's Profit and Loss State- 
ment. The accountant in rare circumstances may be 
called upon to make * ' special examinations ' ' for the 
benefit of consumers, as in a public-utility case. The 
accountant, then, usually studies the individual busi- 
ness, whereas the economist studies all businesses 
and their inter-relations. 

It has often been pointed out that accounting is 
merely a science of classification, analogous to 
anatomy. Economics not only describes and classi- 

» See Chapter III. 



6 ECONOMICS FOR THE ACCOUNTANT 

fies but attempts to give ultimate explanations. A 
scientific explanation, however, is, in one sense, 
merely a description of cause and effect. It may 
be that the economist should have worked out the 
principles on which accounting classifications should 
be based, but economists have been so busy studying 
society and businesses collectively that they have 
neglected to consider the science of business from 
the individual producer's point of view. So the 
accountant has had to work out principles and set 
up theories behind his classifications, because all 
serviceable classifications are built on principles and 
even theories. But inasmuch as the two professions 
are dealing with the same phenomena, and since both 
the accountants and the economists are primarily 
describing facts, their points of view may be differ- 
ent, but, in the last analysis, they should be recon- 
cilable. 

Even though the accountant works for some par- 
ticular producer, that producer functions in a 
complicated economic system, about which the 
accountant must have some knowledge. The pro- 
ducer has contacts with the market, in which there 
are other producers and consumers; he also has 
contacts with capitalists and with laborers. The 
accountant must know something of the intricate 
system in which his employer functions. He cannot 
build a wall around the business for which he is 
making classifications; he cannot tell his employer 
"so much you must add to cost before arriving at 
selling price" and '*in this way you should value 
your assets" if the market refuses to consider the 



ECONOMICS AND ACCOUNTING 7 

employer's or the accountant's ideas and desires in 
the matter. That accountant is most successful who 
is aware of the place of his house in the greater 
economic organization. It will be shown, for ex- 
ample, that his house seeks through price to get 
income from the larger economy and that it draws 
upon that economy for the goods and services for 
which it meets costs; the difference is profit. 
Strangely enough, however, costs are not always so 
easily defined as they might seem to be ; as a result, 
with the varying definitions of costs, there are vary- 
ing definitions of profit. The accountant's definition 
of cost is not always identical with that of the 
economist, and likewise their definitions of profit will 
differ. It is evident that some reconciliation is neces- 
sary, but a rather careful scrutiny of both economic 
and accounting categories must precede the state- 
ment of this reconciliation. Moreover, the economist 
does well to consider the accountant's problems and 
findings. The accountant is working at the heart 
of economic realities and he sees facts and truths 
that the economist may be too much in the clouds to 
recognize. Too many economists maintain their per- 
spective at such a height that they fail to see the 
homely truths that are apparent to the burrowing 
accountant. This book attempts to establish between 
them contacts that should be mutually beneficial. 



CHAPTER II 

THE accountant's PROBLEMS 

The accountant must be able to obtain from tbe 
records of a company data that will answer three 
principal questions: (1) What were the sales or in- 
come and the expenses or outgo of the business in 
any particular period? (2) What were the specific 
costs of the different products handled or produced? 
and (3) How much capital was invested in the busi- 
ness and how can the present worth of the business 
be estimated? The Profit and Loss account, the Cost 
Statement, and the Balance Sheet are constructed by 
the accountant in order to answer these questions. 
These three statements can be used to answer ques- 
tions other than those suggested and some of the 
additional questions, which are significant, will be 
treated in other places in this book. 

The Balance Sheet. — The Balance Sheet is sup- 
posed by many accountants to give merely an ac- 
curate financial picture of the business at a particular 
time, but this belief is due to a misconception of the 
possibilities of determining such an accurate state- 
ment. It will be shown that the Balance Sheet 
should contain the original cost of the assets not 
their market valuation; but it is a question whether 
a statement of this kind could be used to give the 
stockholders or the creditors any idea of the market 

8 



THE ACCOUNTANT'S PROBLEMS 9 

value of the assets at the time the Balance Sheet is 
being used. (See Chapter XI.) 

For whom is the Balance Sheet made ? Obviously 
for those who own the business. To the common 
stockholders (or, as will be shown later, the entre- 
preneur), who own the business, the accountant is 
responsible; his statements are made for them. On 
the one side (according to American custom, the left 
side), the different assets are enumerated and some 
monetary evaluation is set beside each ; legally these 
assets belong to the common stockholders. On the 
right side, the stockholders ' obligations to the banks 
and to the bondholders (or other creditors) are first 
shown and underneath these liabilities are included 
the Common Stock and Surplus, which represents 
the excess of assets over liabilities, and which belong 
to the common stockholders. The form of Balance 
Sheet recommended for the use of manufacturers by 
the Federal Eeserve Board is presented on pages 10 
and 11. 

This Balance Sheet is supposed to serve a number 
of purposes. First, it should give the accountant a 
record of the amount of capital invested in the busi- 
ness ; as a basis for an interest charge or for measur- 
ing the return earned, the amount of capital invested 
represents a very important figure. The Balance 
Sheet will give the amount of capital invested, if 
assets are shown at original cost. Second, it is com- 
monly used by the stockholders, directors, and man- 
agers to obtain an estimate of the financial condition 
of their business at any time. Third, it furnishes 
them with a statement for the bank from which 



10 ECONOMICS FOR THE ACCOUNTANT 

Form of Balance Sheet Recommended 

ASSETS 

Cash: 

la. Cash on hand — currency and coin 

16. Cash in bank 



Notes and accounts receivable: 

3. Notes receivable of customers on hand (not 

past due) ;•••.•• 

5. Notes receivable discounted or sold with in- 
dorsement or guaranty 

7. Accounts receivable, customers (not past due) . 
9. Notes receivable, customers, past due (cash 

value, $) 

11. Accounts receivable, customers, past due (cash 

value 5, .... ) 

Less: 

13. Provisions for bad debts 

15. Provisions for discounts, 

freights, allowances, etc 



Inventories: 

17. Raw material on hand 

19. Goods in process 

21. Uncompleted contracts 

Less payments on account thereof. 

23. Finished goods on hand 

Other quick assets (describe fully) : 



Total quick assets (excluding all investments) . 



Securities: 

25. Securities readily marketable and salable with- 
out impairing the business 

27. Notes given by officers, stockholders, or 
employees 

29. Accounts due from ofl&cers, stockholders, or 
employees 



Total current assets 

Fixed assets: 

31. Land used for plant 

33. Buildings used for plant 

35. Machinery 

37. Tools and plant equipment 

39. Patterns and drawings 

41. Office furniture and fixtures 

43. Other fixed assets, if any (describe fully) . 



Less: 

45. Reserves for depreciation. 



Total fixed assets 

Deferred charges: 

47. Prepaid expenses, interest, insurance, taxes, etc. 
Other assets (49) 

Total assets 



THE ACCOUNTANT'S PROBLEMS 11 



BY THE FeDEKAL RESERVE BOARD 

UABILITIES 

Bills, notes, and accounts payable: 
Unsecured bills and notes: 

2. Acceptances made for merchandise or raw 

material purchased 

4. Notes given for merchandise or raw 

material purchased 

6. Notes given to banks for money borrowed . . 

8. Notes sold through brokers 

10. Notes given for machinery, additions to 

plant, etc 

12. Notes due to stockholders, officers, or 
employees 

Unsecured accounts: 

14. Accounts payable for purchase (not yet 

due) 

16. Accounts payable for purchases (past due). 
18. Accounts payable to stockholders, officers, 

or employees 

Secured liabilities: 

20o. Notes receivable discounted or sold with 
indorsement or guaranty (contra) 

206. Customers' accounts discounted or 
assigned (contra) 

20c. Obligations secured by liens on in- 
ventories 

20c?. Obligations secured by securities de- 
posited as collateral 

22. Accrued liabilities (interest, taxes, wages, 

etc.) 

Other current liabilities (describe fully) : 



Total current liabilities 

Fixed liabilities: 

24. Mortgage on plant (due date ) 

26." Mortgage on other real estate (due date ) 

28. Chattel mortgage on machinery or equipment 

(due date ) 

30. Bonded debt (due date ) 

32. Other fixed liabilities (describe fully) : 



Total liabilities 

Net worth: 

34. If a corporation: 

(a) Preferred stock (less stock in treasury). 
(6) Common stock (less stock in treasury). 

(c) Surplus and undivided profits 

Less: 

(d) Book value of good will 

(e) Deficit 



36. If an individual or partnership: 

(o) Capital 

(6) Undistributed profits or deficit. 

Total , 



12 ECONOMICS FOR THE ACCOUNTANT 

they may desire to secure credit. This third purpose 
explains the arrangement of the assets : the fluid as- 
sets, those that can be easily liquidated in case of 
emergency, are shown first. Probably the greatest 
theoretical difficulty presented by the Balance Sheet 
is the principle of evaluation of the assets. Should 
they always be valued at their original cost, or 
should they be revalued with an increase in their 
market value due to an outside demand, increased 
quantity of money, or greater productivity? These 
questions, which are really economic rather than ac- 
counting questions, can only be answered by ac- 
countants who have a clear understanding of the 
meaning of economic categories. (See Chapter 
XI). 

The Profit and Loss Account. — If the accountant 
needed to find the profit or loss of the stockholders 
realized in a period, it might be supposed that he 
could compare the Balance Sheet for the beginning 
of the period with the Balance Sheet for the end of 
the period.^ There are certain practical difficulties 
involved in arriving at profit in this way: as a 
matter of fact, the second Balance Sheet is ordi- 
narily derived from the first after the profit during 
the period has been determined and added to the 
surplus. Unless assets are revalued, and it will be 
shown that this would be bad accounting, the two 
Balance Sheets would only differ by the amount of 
the profit or loss. Furthermore, even if revaluation 
were allowed, the accountant would find it necessary 

* This profit would not be pure economic profit but a combination of 
profit and interest on the capital invested by the stockholders. 



THE ACCOUNTANT'S PROBLEMS 



13 



Profit and Loss Account Recommended bt the Federal 
Reserve Board 

Comparative statement of profit and loss for three years ending 19 , 





Year ending — 




19— 


19— 


19— 




$ 


$ 


« 


Less outward freight, allowances, and returns . 


Net sales 








Inventory beginning of year 








Purchases, net 
















Loss inventory end of year 








Cost of sales 








Gross profit on sales 








Selling expenses (itemized to correspond with 
ledger accounts kept) 








Total selling expense 






■ 


General expenses (itemized to correspond with 
■ ledger accounts kept) 








Total general expense 








Administrative expenses (itemized to cor- 
respond with ledger accounts kept) . . 
























Total expenses 




... 




Net profit on sales 








Other income: 

Income from investments 








Interest on notes receivable, eto 
















Gross income 








Deductions from income: 

Interest on bonded debt 








Interest on notes payable 
















Total deductions 








Net income — profit and loss 








Add special credits to profit and loss 








Deduct special charges to profit and loss 
















Profit and loss for period 








Surplus beginning of period 
























Dividends paid 
























Surplus ending of period 

































14 ECONOMICS FOR THE ACCOUNTANT 

to separate profits from the sales of products pro- 
duced or handled from gains on the sale of assets. 
The Profit and Loss account on page 13 was recom- 
mended by the Federal Reserve Board in the same 
pamphlet from which the Balance Sheet on pages 
10 and 11 was taken.^ 

The Profit and Loss account gives a financial sum- 
mary of the transactions of a business throughout a 
definite period. It sets forth the income or sales and 
the outgo or expenses in order to show the differ- 
ence, that is, the profit realized. The accountant's 
principal difficulty lies in determining what to do 
with the producer's or stockholders', that is, the 
entrepreneur's, sacrifices, which are not represented 
by actual expenditures, such as depreciation, rent 
on land owned, and interest. On the treatment of 
these much disputed items in accounting economic 
theory can throw much light (see Chapter X and 
Appendix I). 

The Cost Statement. — In a business in which only 
one product of one grade and of one size is handled, 
there is no need for any separate Cost Statement 
provided the items of expense are analyzed and not 
thrown together in one lump sum such as is done on 
the foregoing Profit and Loss account. Although 
the item ''Cost of Sales," as shown, represents a 
summary of the costs, it is often analyzed on the 
Profit and Loss account. For a manufacturing busi- 

2 There is one obvious criticism of this Profit and Loss account, 
which was constructed for a jobbing rather than a manufacturing 
business: Cost of Sales should include Selling and General and Ad- 
ministrative Expense. The item "Cost of Sales" should have been 
called Cost of Goods Sold. 



THE ACCOUNTANT'S PROBLEMS 



15 



ness it could be analyzed about as indicated in the 
following statement: 

Cost Statement, January 1-December 31 



Quantity of Product Man- 
ufactured (pounds, tons, 
or cases, etc.) 



(Add) 
Quantity of Product on 
hand January 1 



{Deduct) 
Quantity of Product on 
hand December 31 



Quantity of Product Sold . 



Raw Materials . . . 

Wages 

Factory Overhead. 



Total Factory 

(Add) 
Cost of Inventories on 
hand January 1 



Total 

{Deduct) 
Cost of Inventories on 
hand December 31 



Manufacturing Cost of 
Goods Sold 

General and Administra- 
tive 

Selling 



Cost of Sales . 



From this statement the different costs per unit 
of product can be obtained by dividing the quantity 
produced into the various production costs or the 
quantity sold into the administrative and selling 
expenses or the cost of sales. Obviously when a 
number of different products of different sizes and 
grades are produced or handled, the problems of cost 
accounting become more difficult. Even if a careful 
record is kept for the costs of the raw materials go- 



16 ECONOMICS FOR THE ACCOUNTANT 

ing into each of the different products of the dif- 
ferent sizes and grades manufactured, there are 
many costs that are not so easily allocated. It will 
be shown in Chapter IX that even with careful 
records the allocation of the raw-material costs for 
co-products and joint-products may present a very 
complicated economic problem. The allocation of 
labor costs represents another difficulty, particularly 
if the same laborers work on a number of the differ- 
ent products or on the different sizes and grades of 
the same products. The most difficult problem, how- 
ever, is presented by the overhead. A reasonable 
allocation of light, heat, and power, of rent, or of 
administrative salaries takes much of the accoun- 
tant's thought; to the solution of this problem, the 
economist can add but little. When it comes to the 
determination of what items should be included in 
cost, and the reasoning pertinent to the disputed 
items, however, the economist can add much. 

The economist is interested in a speedy and ac- 
curate solution of these problems of the accountant. 
Economically desirable differences in prices for the 
different commodities of the various sizes and grades 
can only be determined after accurate costs have 
been established. Furthermore, economies in pro- 
duction can be best effected by accurate and compre- 
hensive unit costs. The economist talks much of 
the proper or most economic proportions of labor, 
capital goods, and land in production. He insists 
that one of the principal functions of management 
is the judicious use of these factors. It will be shown 
that the comparisons of the itemized unit costs of 



THE ACCOUNTANT'S PROBLEMS 17 

the different factories, or for tlie different proc- 
esses, or for the same factory or process for dif- 
ferent months or years enable those responsible to 
effect the necessary economies in production. 



CHAPTER III 

CONSUMPTION" AND PliODUCTION 

The Definition of Economics and Its Subdivisions. 

— Economics is the social science that deals with man 
in his efforts to make a living or to satisfy his wants. 
There are two processes involved: one is concerned 
with the satisfaction of man's wants; the other is 
concerned with the efforts of man in obtaining those 
things that he desires. The first of these processes 
is called Consumption; the second is called Produc- 
tion. In the simplest type of economic organization, 
Crusoe desired food, clothes, and shelter (this is, he 
desired to consume) and he, therefore, had to exert 
ejffort (that is, produce) in order to satisfy his 
wants. Consumption is both the beginning and the 
end of economic study: it furnishes the incentive for 
economic endeavor and it constitutes the ultimate 
purpose of all economic organization. It is seldom 
that man produces merely for the love of producing; 
he produces, or lends others aid in production, ordi- 
narily because he desires to consume and because 
under no other condition would he be permitted to 
do so. Economics considers every human being a 
consumer, whenever he has a desire and obtains 
(purchases) satisfaction. The consumer procures 
satisfaction, although what he apparently purchases 
are ** goods or services. '* A **good" is a physical, 

18 



CONSUMPTION AND PRODUCTION 19 

but not necessarily a tangible, thing that gratifies 
the consumer's desire. A ''service" is the result of 
human effort that takes no purely physical mani- 
festation. Consumption might seem to presuppose a 
reduction of the amount of matter in existence. 
When a man eats a peach, he destroys the form of the 
peach, but the amount of matter in existence is not 
reduced. Furthermore, much consumption does not 
even change the form of the thing consumed. The 
owner of a painting appropriates but he does not 
destroy or even alter the form of the thing consumed. 
Furthermore, consumption does not necessitate ap- 
propriation. The owner of a painting is not the 
only one who consumes it, that is, derives satisfac- 
tion from it. 

Production. — Production logically comprises all 
the processes that are necessary to give the consumer 
the goods and services he desires. Production in 
the economic sense does not mean the actual creation 
of matter. Man cannot bring matter into being; 
he can merely change its form. Tables and chairs 
are made out of wood, which in turn comes from the 
trees; but the trees grow and are not the creation of 
man. Production does not consist in changing only 
the form of goods; it includes also the placing and 
keeping of goods so as to give the consumer his sat- 
isfactions where and when he wants them. Chang- 
ing the form of goods is called the production of 
form utilities, whereas changing their location and 
keeping them until they are needed are called the 
production of place and time utilities. The econo- 
mist, therefore, maintains that what he calls place 



20 ECONOMICS FOR THE ACCOUNTANT 

and time utilities are as important as form ntilities. 
The retailers, the jobbers, the railroads, and the cold 
storage warehouses are as truly producing agencies 
as are the farmers and manufacturers, even though 
they merely store and transport goods and do noth- 
ing to change their form/ 

Some goods that provide the consumer with satis- 
faction do not occupy very much of the economist's 
attention. The economist is only interested in those 
goods for which the consumer is willing to pay a 
price. Some goods, such as air and sunshine, are 
called free goods because they are not usually limited 
in amount and, therefore, do not command a price. 
Goods that are limited in amount and that con- 
sumers desire (usually have to buy) are called eco- 
nomic goods. Economic goods usually have to be 
produced, although mere scarcity plus desiredness 
are sufficient qualifications. The distinction be- 
tween free goods and economic goods is not always 
well defined. Sea shells, wild mushrooms, and 
blackberries may be free goods for persons in cer- 
tain districts, and may be obtained through the ex- 
penditure of only personal labor; but for consumers 

* The accountant 's conception of production is often narrow and 
confined to the direct creation of form utilities. The workers in a 
factory are sometimes called "productive laborers" whereas the 
members of the office force are spoken of as "non-productive 
laborers." Without the clerical force the creation of even form 
utilities would be practically impossible; thus, the economist makes 
no such distinction. Furthermore, the accountant does not consider 
the selling expense as a part of the "cost of production"; but the 
economist insists that selling, which represents the arrangement for 
the creation of place and probably time utilities, is as productive as 
the factory laborer's direct work on the product. Thus, clerical 
work, selling, jobbing, and transportation are as much production as 
farming or the direct creation of form utilities. 



CONSUMPTION AND PRODUCTION 21 

in the heart of a great city they would be economic 
goods. Many economic goods that embody no form 
utilities but only place and time utilities may have 
been free goods in their original habitat. 

Some economic goods are produced that do not in 
themselves gratify the consumer's wants. A ma- 
chine for making shoes is such a good. It fills the 
need of the shoe manufacturer, as producer, but not 
as consumer. The shoes made by this machine 
would gratify the consumer's wants directly and, for 
that reason, are called consumption goods. The ma- 
chine, which is merely used in the production of 
another good, is termed a production good. It will 
be shown later that production goods are usually 
called capital goods. 

It has been explained that practically every eco- 
nomic good has to be produced; either its form has 
to be changed or it has to be transported where, or 
kept until, it is needed. The farm, the mine, the rail- 
road, the steamship, the warehouse, the dealer's 
shelves, all are scenes of production. Economics 
divides the agents or factors of production in four 
classes : laborers, owners of land and capital goods, 
capitalists, and entrepreneurs.^ An analysis of these 
factors of production and of the services they per- 
form is absolutely necessary for an understanding of 
our economic system. 

Labor. — ^Production requires, first of all, human 
effort, both mental and physical. Practically all 
human effort, whether mental or physical, is classed 

'This classification is somewhat different from those usually given 
in the texts, but its value will soon be evident. 



22 ECONOMICS FOR THE ACCOUNTANT 

as labor. Economics puts the farm laborer, the 
bricklayer, the brakeman, the salesman, and the min- 
ing engineer in the same category: they are all 
laborers, and their remunerations are called wages. 

In the earliest stages of civilization the family 
could produce practically all the things it needed. 
Probably the most fundamental distinction between 
such a simple, Crusoe system and our complicated 
economic organization is to be found in the greater 
division of labor that prevails to-day. In the modern 
factory system of production nearly every laborer 
specializes in one relatively simple process. The 
worker in a modern shoe factory does not make an 
entire shoe: he completes only one part of it and 
then hands it over to another worker who adds some- 
thing more. This division of labor and the resulting 
specialization of function have enabled the same 
number of men to produce a larger quantity of 
goods in the same time. 

Land. — ^But human efforts, alone, will not avail in 
production; nature must do her part. Man cannot 
even exist without the air and sunshine, but indis- 
pensable as they are, they are free and, therefore, 
are not classed independently as economic factors of 
production. Only those factors of production are 
considered economic that are so limited that they 
must be paid for. Although producers do not have 
to pay for air and sunshine, they usually have to 
secure a plot of ground or the temporary right to 
stay on a plot of ground before they can produce, and 
with the ground goes the indispensable air and sun- 
shine. All these natural agents are classed in the one 



CONSUMPTION AND PRODUCTION 23 

category, land; the renumeration, which producers 
give to the owners of land for its use, is the most 
important kind of rent. 

Capital Goods. — It might appear that nature, con- 
trolled directly by human efforts, would supply all 
of man's desires. In a sense, this is true, hut nature 
is formidable and man's body is weak. His brain 
has enabled him to contrive tools with which to pro- 
duce the form, place, and time utilities necessary for 
his satisfactions. Thus, when he wishes to dig into 
the soil, he does not go to it directly with his hands, 
but fashions a spade, and before he attempts to re- 
move boulders, he obtains dynamite. It will be re- 
membered that such things as spades and dynamite, 
when used by producers for making consumption 
goods, are called production goods. When used in 
production, they are called capital goods. Capital 
goods, then, are all the goods and instruments used 
by the producer in the productive process. The flour 
miller's wheat and sacks, as well as his machinery, 
are his capital goods. 

Before a producer can produce on any considerable 
scale, he must obtain the capital goods necessary for 
his production. If he needs a building and ma- 
chinery and borrows them from those who own them 
he pays rent or royalty for their use just as he does 
when he needs and leases land. For this reason, the 
business man seldom sees any distinction between 
capital goods and land. As a matter of fact, the 
most significant distinction between them lies in the 
fact that capital goods are commonly produced by 
man's efforts, whereas land is not. Furthermore, 



24 ECONOMICS FOR THE ACCOUNTANT 

the stock of capital goods can be increased but the 
amount of land cannot. Land would be a free good 
even to-day were it not for the physical limitations 
of space and time. When land is improved, it repre- 
sents a combination of land and capital goods. 

Capital. — ^As a matter of fact, however, capital 
goods are not usually rented; the producer must 
purchase them. This is often just as true of land. 
He purchases them with what is called capital, which 
is expressed in monetary terms. Producers some- 
times consider their "capital" as the aggregate of 
their capital goods, and sometimes as the value of 
this aggregate. They express these capital goods in 
monetary terms because in no other way could they 
add together such unlike things as machinery, raw 
materials, buildings, and land. Such conceptions of 
capital might lead to the belief that it is directly 
productive. The best way to define capital is by 
genetic definition, that is, to tell how it is created. 

When those who help to produce receive recom- 
pense, they are commonly rewarded in units of the 
medium of exchange, that is, dollars and cents. This 
money has no value in itself except in so far as it 
represents a claim on desirable goods or service. If 
the claimants in distribution can forego the pleasure 
of spending their money, they save it and amass 
what is called capital. This capital is not necessarily 
money, that is pieces of gold; it is merely a claim on 
goods, but it is always expressed in terms of money 
because, as has been explained, money is the only 
common denominator for all goods and because 
money always represents a claim on goods. Capital, 



CONSUMPTION AND PRODUCTION 25 

then, from the point of view of its owners represents 
accumulated and postponed claims on consumption 
goods, expressed in terms of money. When it is 
transferred from its owners to producers, it becomes 
productive capital and its principal use is for the 
purchase of capital goods. Its owners are only will- 
ing to forego their claims on consumption goods and 
transfer them to producers, if they have reason to 
believe that these claims will be returned to them in 
the future and that they will receive interest. 
Interest, then, is the payment made to the capitalist 
for the use of capital. 

The producer takes this capital, or these post- 
poned claims on goods, and obtains capital goods 
or land therewith. (The other use of capital, namely 
for the payment of wages, interest, rent, and profit, 
will be explained later.) From the producer's point 
of view the capital is thereby dissipated by being 
given to the manufacturers or sellers of the capital 
goods, but from the point of view of the owners of 
capital, it remains intact. Their claims have now 
become contingent claims on definite units of capital 
goods, which legally, however, are in the possession 
of the producer. The producer still must maintain 
the concept of capital, as it forms the basis on which 
he pays interest. Capital, then, is an aggregate of 
postponed claims to consumption goods and is the 
basis of interest payments, whereas, capital goods 
are the physical instruments used in production.^ 

Now, as already stated, capital must not be con- 

'See Chapter XI for the full explanation of capital and capital 
goods. 



26 ECONOMICS FOR THE ACCOUNTANT 

fused with money, although it is always expressed 
in monetary units, and although like money, it repre- 
sents a claim on goods. If all the tools, machinery, 
land, raw materials, etc. were expressed in money 
value and added together, they would amount to 
very much more than the total quantity of the 
medium of exchange existing at that time, even 
though it included coins, bank notes, drafts, and 
checks. Capital is not synonomous with money : the 
total claims of those who forego consumption can be 
expressed in monetary units but they are much 
greater than the quantity of the medium of exchange 
in existence.* Bonds and stocks may, and usually 
do, represent capital but they are not money, that 
is they do not circulate as media of exchange and are 
not legal tender.** 

The Entrepreneur. — It would appear that human 
efforts, the gifts of nature, and the instruments 
fashioned by man are all that are necessary in pro- 
duction. In the modern economic organization of 
society, however, there is another factor, the entre- 
preneur. The entrepreneur is the producer about 
whom so much has been already said. He is the man 
(or group of men) in a business organization who 
controls its policies because he has legal title to its 
capital goods and its product. He is not necessarily 
the capitalist, for he may borrow all the capital he 
uses. If he does invest some or all of the capital, he 
is an entrepreneur-capitalist. In a private business 

* See Chapter XI for the full explanation of capital and capital 
goods. 

» See Chapter VII. 



CONSUMPTION AND PRODUCTION 27 

the entrepreneur is the ''boss" ; in a partnership, the 
partners ; in a corporation, the common stockholders. 
It might seem as if the president of a corporation 
corresponded to the ''boss" in a private firm; but a 
little reflection will show that the stockholders of a 
corporation are legally the "toss/' because they 
own the business, the capital goods, and product, and 
because they control the policy of the corporation. 
The president is merely a salaried laborer, hired by 
the stockholders. 

It has been stated that in the modem corporation, 
the common stockholders constitute the entrepre- 
neur. As the great bulk of the businesses in the 
United States to-day are corporations, it seems neces- 
sary to consider somewhat in detail this form of 
business organization. The corporate form of organ- 
ization has been developed to obviate certain difficul- 
ties of the private firm and partnership. A corporate 
charter enables a business organization to continue 
automatically after the death of its owners, whereas 
a partnership has to be dissolved and reorganized if 
one of the partners dies. A corporation is owned by 
a number of stockholders, who holds stocks or shares, 
usually valued at $100 each, as evidence of owner- 
ship. A corporation can obtain capital by selling 
these stocks to those who desire to become partners, 
but the stockholders are not personally liable for the 
debts of each other or for the debts of the corpora- 
tion. This limited liability of the stockholders makes 
the corporation a far more desirable form of busi- 
ness organization than the partnership, where the 



28 ECONOMICS FOR THE ACCOUNTANT 

partners are personally liable for the debts of the 
business. 

Every holder of a common stock has a vote and 
the holders of the majority of the common stocks 
have control of the corporation. The common stock- 
holders usually obtain their common stock by pur- 
chase; thus, they supply the corporation with capital 
when they become the entrepreneur. If a capitalist 
purchases 1000 shares at $100 each, he supplies the 
corporation with $100,000 capital. For this reason, 
the common stockholders are usually capitalists as 
well as entrepreneur, but if they supplied the cor- 
poration with no capital when they received their 
common stocks, they have the entrepreneurial but 
not the capitalistic function. The entrepreneurial 
function, then, consists in having the majority vote 
in, or control of, the corporation. Furthermore, the 
stockholders, even if they do not supply any capital, 
legally own the business, that is the capital goods 
and the product. If the business earns more than 
enough to pay expenses, the stockholders may re- 
ceive a dividend; if nothing is earned, however, 
nothing can be paid. The stockholder, therefore, 
takes his chances. 

If a corporation desires to obtain capital without 
selling common stock and, thereby, increasing the 
number of partners, it can borrow from the banks 
on notes or loans or it can sell bonds or preferred 
stock. But on all such borrowings it must pay a 
fixed rate of interest. The bondholders supply capi- 
tal, but they have no vote; in lieu of this, they 
demand an assured interest return. If the bonds 



CONSUMPTION AND PRODUCTION 29 

issued are mortgage bonds, the bondholders have a 
right to foreclose, that is, take over and sell the 
specific capital goods mortgaged, in the event that 
their interest is not paid. The preferred stock- 
holders in most modern companies are also supposed 
to receive a fixed return, called a dividend, but really 
interest. Although the preferred stockholders have 
no mortgage, and cannot sell a specified part of the 
company's property if their interest is not paid, their 
interest is usually cumulative, that is, if the 7 per 
cent due them this year is not paid, they are entitled 
to receive 14 per cent next year, before any 
dividends on the common stock can be declared. 
Furthermore, although the common stockholders 
have the vote and the preferred stockholders have 
no voice in the management as long as they receive 
their specified return, the preferred stockholders are 
sometimes given the voting control of the corpora- 
tion if their interest or preferred dividend is not 
paid. This contingent right to vote is not an evi- 
dence of partnership, but is merely a club over the 
corporation and serves much the same purpose that 
the bondholder's right to foreclose under a mortgage 
does. 

The bondholders and preferred stockholders 
are pure capitalists and have none of the entre. 
preneur's function. The sinking-fund provisions, 
which are intended to wipe out the bonds and pre- 
ferred stocks year by year until they are all can- 
celed, show that these two classes are not partners 
but creditors. Thus, although the common stock- 
holders are entrepreneur and may be capitalists as 



30 ECONOMICS FOR THE ACCOUNTANT 

well, the preferred stockholders and the bondholders 
are capitalist but not entrepreneur. 

In the days when most producing units were small 
unincorporated businesses and partnerships, the 
function of the entrepreneur was definitely vested in 
one or two men, but in these days of incorporation 
the problem is more complicated; the stockholders 
legally own the product and the capital goods, it is 
true, but in most cases only a small group of them 
control the policy of the company. Furthermore, the 
voting trust has complicated matters still further; 
in a voting trust the stockholders delegate their vot- 
ing rights to the voting trustees and thereby relin- 
quish their control for a temporary period, at least. 
Generally speaking, the function of the entrepreneur 
is divided between the controlling stockholders of a 
corporation although all of the stockholders have 
some of the entrepreneurial function in that they are 
joint owners of the capital goods and the product. 
A more complete exposition of the entrepreneur and 
his functions will be set forth in Chapter XII. 

The accountant often confuses the entrepreneur 
and the capitalist. Although the entrepreneur holds 
title to the capital goods, he does not always supply 
the capital, and in so far as he does so, he is a capi- 
talist and not an entrepreneur . It should be empha- 
sized that the capitalist owns the capital, whereas 
the entrepreneur has legal title to the capital goods. 
The fact that the two functions are so often embodied 
in one man is no reason for confusing them. The 
promoter, who may or may not he the entrepreneur, 
usually secures, or has someone else to secure, the 



CONSUMPTION AND PRODUCTION 31 

land and capital and then brings the capital goods 
and the labor together; but the entrepreneur is not 
necessarily a capitalist, a landowner, or a laborer, 
and yet he may be all three. If he gives his time 
and actually works in his business after it has been 
organized, he is a laborer and usually receives a 
salary for his efforts. But the entrepreneur may 
have no active connections with his business, as for 
example, the majority of the common stockholders 
of modem corporations, who merely sign a proxy 
once or twice a year. In that case, then. Jus only 
functions would be the control of the policy through 
the ownership of the capital goods and the product. 
The Division of Labor, Distribution, and Ex- 
change. — ^In the simplest kind of economic system, 
each man or each family produced independently 
all the things that were needed. The consumer 
directly consumed the goods that he, himself, pro- 
duced. In our modern complicated economic organ- 
ization, few persons produce, or help to produce, 
more than one kind of thing. Indeed, most laborers 
are expected to complete only one small part of a 
complicated manufacturing process. It has already 
been explained that such a division of labor makes 
possible a great increase in product, but it obviously 
complicates the division of the product. When 
Robinson Crusoe worked alone, all that he produced 
was his; but when Friday helped him a division of 
the product became necessary. The problem became 
even more difficult when the product had to be 
divided between the laborers ; the owners of the land 
or capital goods, who rented them to the entre- 



32 ECONOMICS FOR THE ACCOUNTANT 

preneur; the capitalist, who supplied the capital, and 
the entrepreneur, himself. Obviously, these four 
factors of production would have found it incon- 
venient to receive remuneration for their help in the 
commodities they were cooperating to produce. 
Some farm laborers are paid in kind, but ordinarily 
laborers are paid money wages; owners of land and 
capital goods are paid money rents or royalties; 
capitalists are paid money interest; and entre- 
preneurs retain money profits. This money is sur- 
rendered to the entrepreneur by the consumers and 
is called by him, * ' Sales, ' ' but by them prices. Price, 
therefore, is the sum of wages, rent, interest, and 
profit. The study of the division of price is called 
** distribution, " and the study of the medium of 
exchange, money, is called *' exchange. ' ' The four 
subdivisions of economic theory, then, are: consump- 
tion, production, distribution, and exchange. 

Another Definition of Economics, — Economics is 
sometimes defined as *'the science that treats of 
phenomena from the standpoint of price."® This 
definition can be easily reconciled with the first one 
given on page 18 when it is realized that price is 
what the consumer must give in order to obtain the 
satisfaction of his desires (consumption) ; it is what 
the producer receives for the efforts expended (pro- 
duction) ; it is the return divided between the four 
factors of production (distribution); it is expressed 
in terms of money, and, as will be shown in Chapter 
VII, bears a close relation thereto (exchange). The 
accountant, too, is interested in price, or ''Sales," 

* H. J. Davenport, Economics of Enterprise, page 25. 



CONSUMPTION AND PRODUCTION 33 

that is, tlie sum total of the prices received. He 
analyzes price somewhat differently; he considers 
price the sum of cost and profit, cost being what the 
entrepreneur pays, and profit what he receives. 
Although cost is analyzed both on the Profit and 
Loss account and in the Cost Statement, the classifi-- 
cation of the accountant differs from that of the 
economist. It will be shovm that the fundamental 
reason for this difference lies in difference in the 
economic and the accounting conceptions of cost.^ 

' See Chapter VIII. 



CHAPTER IV 

DISTRIBUTION 

Distribution and Marketing. — Distribution is the 
branch of economics that deals with the returns 
received by those who aid in production. The 
laborers, the landowners, the capitalists, and the 
entrepreneurs are the claimants in distribution, and 
the explanation of their shares, wages, rent, interest, 
and profit, is one of the principal tasks of the 
economist. Distribution should not be confused with 
marketing, which considers the movement of prod- 
ucts from the producer to the consumer. It might 
seem that when laborers are paid in kind, as on a 
farm, the two problems of distribution and market- 
ing merge into one. If the laborer receives com- 
modities in payment for his services and consumes 
them, the process of distribution has become the 
marketing process. However, it is doubtful whether 
many laborers to-day could satisfy all their wants 
through the consumption of the commodities they 
helped to produce. A farm laborer might receive 
all the food he needed, but he would require many 
things, other than food, and for them he would be 
forced to give a part of the food commodities he 
received as wages. Marketing would consider the 
ultimate destination of the food commodities the 

34 



DISTRIBUTION 35 

farm laborer received as wages, but distribution 
would merely treat tbem as a share of the total 
production and would not consider them after they 
had passed out of the laborer's hands. Inasmuch as 
most laborers, as well as the other factors of produc- 
tion, receive payment in money and not in kind, for 
the obvious reasons that have been suggested on 
page 32 and will be elaborated in Chapter VI, dis- 
tribution is the study of the division into wages, 
rent, interest, and profit of the money prices paid 
by consumers to entrepreneurs, and marketing is 
merely concerned with the movement of goods from 
the producer through the middleman to the con- 
sumer. Whereas farming, mining, and manufactur- 
ing are largely concerned with the creation of form 
utilities, marketing is more definitely concerned with 
the creation of place and time utilities, but market- 
ing is, nevertheless, production and not distribution. 
Whether a commodity is moving from the producer 
to the consumer with the least expenditure of effort 
and whether there are so many unnecessary middle- 
men that the producer's price is loaded with too 
many margins before the commodity finally reaches 
the consumer are the problems attacked by a market- 
ing study. 

The problems of distribution are of a very dif- 
ferent kind. Why do the different factors in produc- 
tion receive their shares in distribution? Why are 
laborers paid wages? Why are rent and interest 
paid? What services do entrepreneurs perform in 
order to earn their profit? Why do wages rise while 
rents or interest may be falling? What explains the 



36 ECONOMICS FOR THE ACCOUNTANT 

total wages paid to laborers in an industry? What 
determines the total amount of the shares paid the 
other factors, the owners of land and capital goods, 
the capitalists, the entrepreneurs? How are the dif- 
ferences in wages, rents, interest, and profits to be 
explained? These are some of the most important 
questions that any theory of distribution should 
attempt to answer. 

The Productivity Theory of Distribution.— If 
there is any one principle that is more fundamental 
than any other in the theories of distribution, as set 
forth by most economists, it is the ''productivity'" 
explanation of the shares in distribution. On the 
third page of Professor J. B. Clark's Distribution of 
Wealth, he makes the following statement: ". . . 
where natural laws have their way, the share of 
income that attaches to any productive function is 
gauged by the actual product of it. In other words, 
free competition tends to give to labor what it 
creates, to capitalists what capital creates, and to 
entrepreneurs what the coordinating function 
creates." Many economists assume the justice of 
this principle, which other economists, including the 
Socialists, challenge. The ethics of this assumption 
cannot be discussed in this book, but the failure to 
treat it constitutes no reason for the belief that it 
cannot be defended. 

The productivity theory of distribution, then, 
maintains that in a truly competitive system laborers 
tend to receive in wages the equivalent of that speci- 
fic part of the product that their services create, 
that the owners and renters of land or capital goods 



DISTRIBUTION 37 

tend to receive in rents or royalties what their land 
or capital goods produce, that the capitalists tend 
to get in interest the productivity of the capital 
goods purchased with their capital, and that the 
entrepreneur gets approximately in profits what he 
adds to the product. In concrete terms, if a laborer, 
working on a piece of land with no instrument (capi- 
tal goods), produces 20 units of product, the 20 
units would be the result of the land's productivity 
and of the laborer's productivity, and if it were 
divided between the landowner and the laborer, it 
might be said to represent wages and rent, equal to 
the product of the laborer and the land. If a 
machine were employed, the productivity might be 
increased to 30 units; then, 10 units would be imput- 
able to the machine, and, according to the produc- 
tivity theory, approximately 10 units of product 
would represent either rent or royalty paid for the 
use of the machine, if it were borrowed, or interest 
on the capital expended, if the machine were bought. 
Later, if an entrepreneur were assumed to increase 
the productivity of the combination of labor, land, 
and capital goods to 40 units of product by some 
adroit innovation, the profit he would tend to get 
would be the 10 units he may be said to have created. 
Although, if certain assumptions are made, the 
productivity theory seems most reasonable and, to 
the author, not unethical, it is a difficult theory to 
prove or even demonstrate.^ Professor John B. 

*With regard to the assumptions referred to, if the laborer is to 
get what he produces, his bargaining power must equal that of his 
employer. This is also true of the bargaining powers of the other 
factors. The disparities in the laborer's and entrepreneur's bargain- 



38 ECONOMICS FOR THE ACCOUNTANT 

Clark and some of his pupils have made the most 
sustained attempt to demonstrate and prove the 
principle that free competition tends to give each 
factor what it produces, and the logic he uses can be 
found in his Distribution of Wealth.^ One corollary 
of the productivity theory, which is somewhat easier 
to demonstrate, is the principle that laborers of dif- 
ferent efficiencies tend to get wages graded accord- 
ing to their relative productivities. 

Wages. — Wages and salaries constitute the share 
of labor. Before production begins they are fixed 
by contract between labor and the entrepreneur or 

ing powers have resulted in the collective bargaining of the trade 
unions, which at times may get for the laborers more than they 
produce. The price agreements of entrepreneurs and their monopo- 
listic control of industry have often secured greater profits for them 
than their productivities could have warranted. Thus, in many ways, 
competition is not free and the factors do not even tend to get their 
productivities. This is all explained in detail in Chapter XIII. 

* The productivity theorist argues that a producer will continue to 
obtain laborers and capital for capital goods, including land, until he 
reaches a point where the last unit of capital goods and the last 
laborer will just pay for themselves, that is, this last unit of capital 
goods and the last laborer will just add enough to the product to 
cover the interest charge and the wage that must be paid. Then if he 
is a wise producer, he will hire no more laborers and buy no more 
capital goods. This last laborer is called the marginal laborer, and 
the last unit of capital goods is called a marginal unit of capital 
goods. Since it is assumed for the purpose of this analysis that all 
the laborers are of equal efficiency, the marginal laborer will produce 
as much as the other laborers, and, furthermore, he will receive a 
wage equal to his productivity, because he is defined as the laborer 
who just pays for himself. The productivity theory, then, goes on to 
show that all laborers cannot be assumed to be equally efficient. 
Professor Clark's words are as follows: "A skilled worker will, of 
course, always create more wealth than an unskilled one. ... A 
good instrument will also produce more than a poor one. Such a good 
instrument, however, represents more units of capital than does the 
poor one; all that we have claimed for competition is a tendency to 
put the different units of capital where their earnings are equal. . . . 
In like manner, a laborer of a high grade embodies in himself more 
units of labor than does an inferior one." Distribution of Wealth, 
page 106. 



DISTRIBUTION 39 

his agents. Laborers and salaried officers receive 
fixed amounts for their services except in those cases 
where bonuses are given, but even then the amounts 
received do not necessarily depend upon conditions 
in the market. This is not true of the amounts 
received by the laborers in a profit-sharing sys- 
tem, which represent a combination of wages and 
profits. 

There are a number of theories that attempt to 
explain how the wages of labor, as a whole, and how 
the wages of laborers, as individuals, are determined, 
but the business man and his accountant have only 
of late become interested in the wage problem. 
Naturally the employer has always tried to pay as 
little as he could, and after he had paid it, his 
accountant merely put the exact amount in cost and 
gave it no further consideration. 

It would be impractical here to describe at length 
all the different theories of wages, and yet it would 
be dogmatic to present and insist upon any one. 
Although the productivity theory, which has already 
been described briefly, has had a great effect on the 
thinking of American economists the cost of living 
or standard of living theory is often introduced as 
a qualification. The cost of living theory of wages 
has been gaining support largely for the reason that 
free competition, assumed by the productivity 
theory, does not exist and as a result labor has not 
always been receiving what it produces.^ The cost 
of living theory, or the standard of living theory, 
might maintain, however, that even if competitive 

» See Chapter XIII. 



40 ECONOMICS FOR THE ACCOUNTANT 

conditions actually were as they are pictured by 
the marginal productivity theory, and even if labor 
tends to receive what it produces, this share may 
not be sufficient. If this share does not give laborers 
a living or a decent wage, it should be increased. 
Even if the capitalists, the landowners, or the entre- 
preneurs have to surrender parts of their shares, 
that is, the results of their productivities, it would be 
better for them to do so than to have laborers under- 
paid. This might imply a less rapid growth of 
capital, but even so it would be preferable to under- 
paid laborers. Furthermore, laborers with a higher 
standard of living and with the educational oppor- 
tunities offered by increased wages would probably 
become more efficient. 

It has been assumed by many economists that 
wages could never fall below a certain point for the 
reason that there is a certain minimum necessary 
for life and that if wages did fall below the minimum 
of subsistence, the consequent decrease in the supply 
of labor would automatically raise wages. However, 
it has come to be realized that wages may fall below 
a decent minimum without necessarily causing 
deaths; undervitalization and consequent physical 
degeneration may affect the labor supply without 
necessarily diminishing its size. The cost of living 
theory of wages assumes that every person who 
plays any part in production should have a living 
wage. The minimum wage, then, is a necessary part 
of any economic organization and should be enforced 
by legislation if it does not come about naturally. 
Above the minimum of subsistence, wages might be 



DISTRIBUTION 41 

determined in mucli the same way as the produc- 
tivity theory maintains. However, according to the 
cost of living theory, general increases in prices 
should be followed by increased wages. Laborers 
should not be forced to reduce their standards of 
living because of increases in the price level. This 
theory, therefore, is often called the standard of 
living, rather than the cost of living, theory of 
wages. 

Rent. — ^It is often asked why a man should be 
allowed to control a piece of land in much the same 
way that he controls his bodily efforts, and why any 
other man should have to pay him for the use of it. 
Land is not created by human efforts and would be 
considered a free good, like air, were it not limited. 
Some undesirable pieces of land, undesirable because 
they are barren or because they are so far removed 
from the centers of population, are free even to-day. 
The payment of rent for land is predicated on the 
principle of private property, which, justifiable or 
unjustifiable, is at the basis of our present economic 
organization. In practically every civilization of the 
world a man has been allowed to hold legal title to 
a piece of land if he were the first to claim it, and 
legal title has always implied the right to hold, trans- 
fer, sell, rent, or bequeath. Many feel that no 
individual should have such rights over the gifts of 
nature unless he be expected to improve them, and 
the more radical contend that under no conditions 
should individuals be permitted to own land, which 
they did not produce and which should be the prop- 
erty of society as a whole. Although the original 



42 ECONOMICS FOR THE ACCOUNTANT 

owner of a piece of land may have no just claim to 
it other than priority, all subsequent owners who 
purchased it with the expenditure of capital prob- 
ably have a better justification for demanding rent. 
Such landowners might almost be classed with the 
capitalists, who saved, inherited, or acquired their 
capital, because their purchase of the land is no dif- 
ferent from the purchase of capital goods. No one 
would deny that a laborer who invested his savings 
in land should be entitled to a return. 

The productivity theory is used to explain rent 
as well as wages. One principle that helps to explain 
the difference in rents is a corollary of the produc- 
tivity theory and can also be applied to profits. It 
is sometimes called the differential theory. If 
marginal land be defined as a piece of land that it 
just does not pay to cultivate, because it is so poor, 
the difference between the product that could be 
raised on this piece of land and on other pieces of 
land, more fertile, would represent the respective 
rents for the more fertile pieces of land. This use 
of the term *' marginal," as in marginal land or 
marginal entrepreneur, must not be confused with 
the other use of this word. The marginal laborer 
of the productivity theory was the last laborer the 
producer could afford to use, and was assumed to be 
of the same efficiency as his other laborers; the 
marginal land of the differential theory is the rela- 
tively poor land just at the margin of cultivation. 
All the other pieces of land command rents equal to 
the excess of their productivity over the marginal 
land. Thus, if a producer undertook to cultivate 



DISTRIBUTION 43 

free land from which he could just earn enough to 
pay interest on the borrowed capital, wages to his 
laborers, and enough for his own scant subsistence, 
he would be cultivating marginal land and would be 
in no position to pay rent. Any land from which the 
same producer with the same help and instruments 
could obtain a larger crop would be super-marginal 
land. For such land he would have to pay rent, and 
this rent theoretically would be equal to the dif- 
ference in the product obtained from marginal and 
super-marginal land. 

Interest. — Whereas wages are paid to laborers, 
and rents to the owners of land and capital goods, 
interest is not paid to the entrepreneur, who has 
legal title to the capital goods, but to the capitalist 
who allowed the capital to be brought into existence 
by foregoing claims to consumption goods. Interest 
on capital is commonly determined upon in advance 
by the entrepreneur and the capitalist. It usually 
represents a fixed percentage of the capital loaned. 
Thus, when the capitalist loans a business capital 
by buying its bonds, he receives a fixed rate of 
interest. The return received by the capitalist who 
lends a corporation capital by buying its stock will 
be considered on page 120. 

The productivity theory maintains that the rate 
of interest is determined by the productivity of the 
capital goods purchased with capital. Some econo- 
mists maintain that the interest rate is far less 
affected by the productivity of capital than by the 
psychology of the savers or capitalists. For example, 
frugal .and provident persons would save capital in 



44 ECONOMICS FOR THE ACCOUNTANT 

order to accumulate a bank account even though 
they were to receive a rate of interest very much 
lower than the productivity of the capital goods 
obtained through the use of their capital. It is often 
questioned whether the rate of interest has as great 
an effect on the accumulation of capital as is usually 
implied in the productivity theory. Certainly the 
provident would provide for old age no matter how 
low the interest rate might be. Furthermore, a shift- 
less person or a nation, suddenly grown extravagant, 
might not forego present consumption for a promise 
of future consumption, no matter how great the in- 
ducement, that is, the interest rate, might be. 

There is another factor that influences the interest 
rate, namely, the risk the capitalist runs of not being 
able to obtain his principal. When a capitalist lends 
his money to a speculative industrial corporation, 
he demands a higher rate of interest than he would 
if he were buying a safe railroad bond. The dif- 
ference in the two rates is sometimes called a pre- 
mium for risk.* 

The interest rate is probably determined (1) by 
the frugality of those who receive incomes and by 
the premium they demand for postponing present 
consumption; (2) by the risk they run of not obtain- 
ing their future consumption; and (3) by the produc- 
tivity of the capital goods the producer can obtain 
with the use of their capital. It is to be hoped that 
concrete statistical work will be carried on in the 
future in order to sharpen our conceptions of the 
factors that determine the rate of interest. 

* This matter will be discussed again on page 140. 



DISTRIBUTION 45 

Profit. — The complete discussion of profit will be 
postponed nntil Chapter XII, where it will receive 
more complete treatment than any of the other 
shares of the claimants of distribution have yet 
received. Profit, the share of the entrepreneur, is 
the most important of any of the shares from the 
accountant's point of view. The entrepreneur has 
the strategic position in the modern organization of 
industry, and the accountant is his agent. The entre- 
preneur theoretically assembles the other factors of 
production, directs the productive process, collects 
from the consumers, and pays off the factors of 
production when they become claimants in distribu- 
tion. These functions give the entrepreneur his 
strategic position in industry. 

Walker called the entrepreneur the captain of 
industry, and he was. In those days, he was the 
individual who controlled industry. But, to-day, we 
are witnessing the passing of the entrepreneur as 
a person; his functions are being surrendered to a 
group of stockholders, the dominant group, and even 
they, in many cases, are delegating most of their 
functions to their hired employees. Yet, the entre- 
preneur's authority still exists; he has the right to 
control the policy of his corporation because he has 
the legal title to the capital goods and to the product. 
Furthermore, in so far as he has anything to do 
with the placing of labor and capital in such a posi- 
tion that the productivities of labor and of capital 
goods are increased, he can claim to be the creator 
of the increased product. It will be shown in Chap- 
ter XII that the entrepreneur's only justification for 



46 ECONOMICS FOR THE ACCOUNTANT 

claiming profit is not risk, as many economists main- 
tain, but productivity, and that if lie is not really 
responsible for the production of what he obtains, he 
has no economic right to it. 



CHAPTER V 

THE economist's PROBLEM 

The Meaning of "Economics." — In Chapter n the 
accountant's problems were discussed. Because it 
was necessary to make some study of the fundamen- 
tal concepts of economics before the economist's 
problems could be understood, they have been post- 
poned for this chapter. It has been stated that 
economics deals with men in their efforts to satisfy 
their wants. There are, therefore, two fundamental 
problems involved: men must *' consume" in order 
to satisfy their wants; men must ''produce" in order 
to obtain the desired satisfactions. For Robinson 
Crusoe there were only two subdivisions of econ- 
omics: consumption and production. He desired to 
consume; therefore, he produced. It may be helpful 
to the student to stop at this point and reconsider 
why the description of these processes is called * ' eco- 
nomics." If Crusoe had produced clumsily, he 
would not have been satisfying his wants ''economi- 
cally." Economics, therefore, considers the method 
employed and the amount of effort expended by men 
in the satisfaction of their wants. Furthermore, if 
Crusoe had eaten too many fish in the evening for his 
physical comfort, and then, had had none left for 
breakfast, he would have been consuming "uneco- 
nomically." An ideal economic system would imply 

47 



48 ECONOMICS FOR THE ACCOUNTANT 

the greatest possible satisfaction for society as a 
whole with the least possible effort. 

For Crusoe alone there were no problems of dis- 
tribution and exchange, but if he and Friday had 
worked together, they would have had to divide the 
product between them. It has been shown that this 
division of the product would have been a very 
elementary type of distribution. In our modern com- 
plex economic organization where a large group of 
people cooperate to produce one commodity and 
where there is an extensive division of labor, the 
laborers could not be paid *'in kind" but must be 
paid in money. The workers in a shoe factory could 
not be given shoes, and, then be expected to go out 
and trade their surplus shoes for the other things 
they desire. Such a system of barter, it will be 
shown in Chapter VII, would be uneconomical. 
Therefore, not only a more complicated distribution 
but a new subdivision of economics, exchange or the 
study of money, distinguishes our present industrial 
organization from the Crusoe system.^ 

Inasmuch as the methods of distribution and 
exchange affect the success with which laborers, 
landowners, capitalists, and entrepreneurs satisfy 
their wants, the economist has always given more 
attention to these two subdivisions than to produc- 
tion and consumption. If the laborers, who represent 
probably 95 per cent of the people, are not getting 
enough for the satisfaction of their wants imder the 
present methods of distribution and exchange, and 
if a few people, the capitalists, the landowners, and 

*See Chapter VII. 



THE ECONOMIST'S PROBLEM 49 

the entrepreneurs, are receiving far more than they 
need for the satisfaction of their wants, the econ- 
omists might be inclined to criticise the present 
system of distribution as uneconomical. Too large 
a part of society would be doing the hard work, and 
too small a part would be getting the necessary satis- 
faction. However, the economist must consider 
whether the laborer's desires could be better satis- 
fied under any other organization of society. If the 
laborers, without the help of the other classes, would 
only produce that part, or less than that part that 
they get at present, there might be some reason for 
saying that the other factors earn their interest, 
rent, and profit and that laborers deserve no higher 
wages than they get. This should be recognized as 
an inference drawn from the productivity theory of 
wages. 

In the past so much attention has been given by 
economists to the question whether our present sys- 
tem of distribution and exchange allows the greatest 
number of people the greatest amount of satisfaction, 
that they have sometimes neglected the problems of 
consumption and production. Consumption, as will 
be shown in Chapter VI, is largely a psychological 
problem, but some of the English and the Austrian 
economists have stimulated much interest in it of 
late years. The problems of production can be at- 
tacked with more effectiveness by the accountant, 
the engineer, and the efficiency expert than by the 
economist. When the economist attempts to form- 
ulate principles of production, he is handicapped by 
the lack of data. His pronouncements on the effi- 



60 ECONOMICS FOR THE ACCOUNTANT 

ciency of large-scale production ^ and on the effect of 
machinery, for example, should have been based on 
inductive studies and not on deductive logic. The 
accountant and the technical expert is probably in a 
better position than the economist to solve many of 
these problems. 

The Study of Prices. — It was explained in Chapter 
III that economics is sometimes defined as *'the 
science that treats phenomena from the standpoint 
of price." It has also been pointed out that the 
study of prices enables the economist to measure the 
effectiveness with which society's wants are being 
satisfied. The consumer must pay a price for prac- 
tically everything he consumes. The extent to which 
the consumer's wants are satisfied by the prices he 
pays is as much a psychological as an economic prob- 
lem, but the economist has a more direct interest in 
it and, therefore, cannot neglect it.^ This price is 
paid to the producer and divided by him between 
the factors of production, who are also claimants in 
distribution. The division of price by the producer 
between the different factors of production has prob- 
ably received more attention from economists than 
any other economic problem. Inasmuch as these 
factors of production are only able to become con- 
sumers through the shares they receive in distribu- 
tion, the economic well-being of consumers depends 
upon the fairness of distribution. If wealth were 
distributed so as to give but little satisfaction to 
those who produced much and too much satisfaction 

' See page 157. 
*See Chapter VI. 



THE ECONOMIST'S PROBLEM 51 

to those who produced little, such a system of dis- 
tribution would be uneconomic, not merely because 
it would be unfair, but also because it would prob- 
ably not encourage and stimulate productivity. 

It will be shown that the economist has three 
principal problems in the study of prices. In order 
to explain a high price, for example, he must con- 
sider first, the demand and the consumer; second, 
the supply and the cost of the producers, which is 
the great limitation on supply; third, the quantity of 
the medium of exchange, in terms of which all prices 
are stated. Chapter VI discusses the relation of 
price to demand. Chapters VIII, IX, X, XI, and XII 
analyze the relation between price and cost. Chapter 
VII considers the relation between price and the 
quantity of the medium of exchange. This analysis 
of price, then, will survey men in all of their eco- 
nomic capacities, in their efforts (production) to 
make a living (consumption), and it will also de- 
scribe the mechanism (distribution and exchange) 
through which they are enabled to satisfy their 
wants in an economic system, which the division of 
labor makes so effective and at the same time so 
complex. 

Practical Economics. — As the world nas become 
more widely settled and more thickly populated, as 
our desires have increased and become more com- 
plex, and as man's ingenuity has contrived newer 
and presumably better methods of satisfying those 
desires, economics has become a more and more com- 
plicated science. Agriculture, mining, manufactur- 
ing, and marketing are not the only problems the 



52 ECONOMICS FOR THE ACCOUNTANT 

economist must consider. Transportation, commer- 
cial geography, foreign trade, foreign exchange, 
banking, insurance, labor problems, and industrial 
management are some of the new branches of applied 
economics that have been developed within late 
years. There should be a particular demand in 
industry, to-day, for specialists in these branches of 
applied economics. It has been shown in Chapter I 
that the first political economists were finance minis- 
ters and university professors. There is a relatively 
small demand for political economists even to-day. 
Although the study of economics seems to thrive only 
in the universities, there is a great need in the gov- 
ernment for an understanding of its principles. The 
business man, however, is not so interested in the 
well-being of society as he is in his own well-being. 
Although he may refuse to consider the economist's 
point of view, if he is wise, he will study the facts 
and conclusions that the economist presents. 

The above mentioned branches of applied eco- 
nomics are being studied by many who contemplate 
entering business life. It has been shown that trans- 
portation is as much a process of production as 
the extractive and manufacturing industries. The 
study of industrial management is especially de- 
signed to help the producer, particularly in his 
efforts to increase production, reduce cost, and 
increase profits. Banking, corporation finance, in- 
vestments, and insurance are all of particular inter- 
est to the producer and should indicate to him sound 
methods of finance as well as the possibility of elimi- 
nating certain kinds of risk. Even labor problems 



THE ECONOMIST'S PROBLEM 53 

are being studied for the benefit of the producer 
rather than for the laborer. Many employers are 
coming to find it necessary to understand the labor 
problem in order to produce efficiently.* It has been 
explained that the accountant is working for the 
producer and has his point of view. The accountant, 
therefore, is also interested in the problems of pro- 
duction; in fact, he is usually assisting in production. 
However, he has another interest in the branches of 
applied economics. He may be called upon to do 
work for a bank, an insurance company, an invest- 
ment banker, or a railroad. Furthermore, in these 
days when most business units are corporations, the 
accountant must understand corporation finance in 
order to do his work properly. 

The scope of this book does not admit of a discus- 
sion of all of these branches of applied economics. 
The fundamental principles of pure economic theory, 
however, must be understood before the problems of 
applied economics can be attacked. Special text 
books on these branches of applied economics should 
be consulted, although some of the fundamental 
principles of banking, corporation finance, and 
taxation will be introduced in the pages to follow. 

*It 13 obvious, however, that the producer vrill become more in- 
terested in a method of increasing production, or, better, profit, than 
in a method of improving distribution. For this purpose, the engineer 
and the accountant are more useful than the economist. 



CHAPTER VI 



PRICE AND DEMAND 



Price. — It has been explained that a thorough- 
going analysis of price would necessarily include the 
whole field of economics. Wages, interest, rent, and 
profit might be called the prices received for the 
services of laborers, capitalists, landowners, and 
entrepreneurs. But even when price is not used in so 
broad a sense, but is limited to mean the money value 
of goods, it may even then be considered the central 
problem of economics. Any man on the street will 
tell you that price is fixed by supply and demand. 
Whether he has analyzed this apparent truism is an- 
other question. When the supply of wheat is great, 
the price will be relatively low, but if the supply is 
small, the price will be relatively high. If the de- 
mand for wheat were to increase, other things being 
equal, the price would increase, and if the demand 
were to fall off, the price would probably decline. It 
is the price mechanism that adjusts supply and de- 
mand. If the supply of wheat in one year is rela- 
tively great, the price falls so that the supply is 
absorbed. When the price falls, producers of wheat 
find it unprofitable to produce this crop and will 
curtail their production in the next period. When 
the production is curtailed, the demand for this 

64 



PRICE AND DEMAND 55 

staple commodity would force up the price to a point 
at which the growing of wheat would again become 
profitable. The price mechanism, then, might well 
be called the balance wheel between demand and 
supply. 

Inasmuch as the producer must ultimately pay 
the factors of production out of price, it is usually 
assumed that price should at least cover his costs, 
which in Chapter VIII will be analyzed into the 
shares claimed in distribution. It is often said that 
the classical economists laid too much stress on the 
relation between price and cost and that they failed 
to consider the other price-determining factors, 
which are to be discussed in this chapter. In 
Chapter XII it will be shown that the price-cost rela- 
tion is a fundamental one and that there is much new 
to be said about it. However, the other factors that 
affect price should not be neglected. The accountant 
is so occupied with the supply side of the equation 
that he often neglects the demand side. The sales- 
man comes in more intimate contact with demand 
than any of the employees of a business organiza- 
tion. On the supply side, cost is the fundamental 
consideration, because the greatest limitation on 
supply is cost.^ But these phases of the problem 
will be discussed in almost all the other chapters of 
this book. In this chapter the factors other than 
supply and cost will be considered. 

^ The reason why there is such a relatively large supply of some 
things is because it does not cost much to produce them, and the 
only reason why other things, very much desired, are not supplied 
in larger quantities is because they are costly to produce. Thus, cost 
and scarcity (as in rare or art objects) are the great limitations on 
supply. 



56 ECONOMICS FOR THE ACCOUNTANT 

The analysis of demand necessitates a study of the 
consumer and his psychology. The consumer is, 
after all, the reason and the purpose for all economic 
organization. All of the accountant's work has for 
its ultimate purpose the satisfaction of the con- 
sumers' wants, although he, like the producer, does 
not always realize it. 

A good is a physical thing that a consumer de- 
sires. A good is said to possess *' utility" for the 
consumer. Goods, whether they are free or eco- 
nomic, possess utilities. When a good is merely use- 
ful, it is said to have a ** value in use"; but when 
it is not only useful but limited in supply, it is an 
economic good and has ** value in exchange." If 
water were a free good, as in a river-bank com- 
munity, it would have merely value in use, but if it 
were limited in supply, as in some inland city, its 
possessor would be able to trade it for other eco- 
nomic goods and it would have value in exchange. 
It is important to note that some of the most vital 
necessities, which have the greatest value in use, as 
for example, air, sunshine, water, iron, wood, may 
have little or no value in exchange; whereas other 
things which have less value in use, as, for example, 
gold and precious stones, have very great value in 
exchange. 

Marginal Utility. — If Crusoe on his desert island 
had been able to save no food except one box of 
crackers from the wreck, that unit of food would 
have had incalculably great utility for him. If 
soon after he had discovered a second box, each box 
would have had a somewhat smaller utility. And 



PRICE AND DEMAND 57 

with tlie discovery of subsequent boxes, the utility 
of each box would have decreased. Even though 
crackers more nearly approach the staff of life than 
any other food, a steady diet of crackers would 
prove nauseating, and the utility of fruits and game, 
which he might have been able to procure on the 
island, might have been greater than the inevitable 
crackers. If the island had readily supplied his food 
needs, an article of clothing would probably have 
had a greater utility than an article of food. Later, 
when all the primary necessities of life were satis- 
fied, a book would have had a greater specific utility 
for him than any unit of food or clothing, even 
though the first units of food or clothing would have 
been indispensable. 

This can be represented graphically as in the fol- 
lowing diagram: 



X - Represents units of the supply 

*j- » »» « »' sat istactjon or utility, 




When the supply is very small, the utility of one 
unit becomes indefinitely great, that is, it approaches 
infinity; but as the supply increases, the utility de- 
creases. When the supply becomes infinite, the 
specific utility of one unit approaches zero, as in 
free goods. The curves for food, for clothing, and 



68 ECONOMICS FOR THE ACCOUNTANT 



for "books might be shown in the same diagram as 
follows: 




A - Food 
B - Clothing 
C - Books 



In the food curve A, a supply so small as to ap- 
proach zero would have a utility approaching in- 
finity. This would not be so true of the book curve 
C. The extent to which the curve for a commodity 
would approach infinite utility with a supply ap- 
proaching zero might be used to furnish a good basis 
for the distinction between luxuries and necessities. 
If Crusoe, after supplying his food, clothing, and 
shelter needs, had di'ed of boredom because he had 
no books, his book curve should have been drawn 
similar to the food curve in the diagram. For 
him, books would have been a necessity. But as 
the book curve is drawn, books are assumed to be 
luxuries. 



PRICE AND DEMAND 59 

It should be noted that, as the curves are drawn, 
it takes fewer units of clothing, curve B, than of 
books, curve C, or units of food, curve A, to satisfy 
Crusoe. Furthermore, after he has had 2x units of 
both clothing and books, thereafter, each new book 
has a greater utility than a new article of clothing. 
If the utilities of the different units of food be added, 
and a continuous curve be assumed, the area bounded 
by the curve and the two axes would represent the 
total utility of food for Crusoe. Inasmuch as the 
first unit of food has a utility approaching infinity, 
the area would be indefinitely great, stretching up 
along the vertical axis. As new units are added the 
total utility is increased, but only very slightly when 
the supply becomes great. 

Although the total utility of clothing is greater 
than the total utility of books, after 2x units of both 
are brought into existence or consumed the utility 
of the third unit of books is greater than the utility 
of the third unit of clothing. This last unit is called 
the marginal unit, and its utility to the consumer is 
called the marginal utility of the commodity. 

Thus, the marginal utility of a product for any 
consumer is the utility of the least desired, that is, 
the last created or consumed, unit of the supply. The 
seeming paradox that things that have little value 
in use may have great value in exchange is ex- 
plained by the marginal utility concept. The total 
utility, determined by the value in use, of food or 
clothing approaches infinity, but their marginal 
utilities, which measure their values in exchange, 



60 ECONOMICS FOR THE ACCOUNTANT 

are relatively small because of the large supply; 
whereas the total utility of diamonds is far less con- 
siderable, but their marginal utility and, conse- 
quently, their exchange value is very great because 
of the limited supply. 

Marginal Utility, Cost, and Price. — The value in 
exchange of a commodity, expressed in monetary 
terms, is its price. The price that any consumer will 
pay for a commodity will be determined by its 
marginal utility to him. In making a choice be- 
tween the various purchases he can make, their vari- 
ous marginal utilities will be measured by him 
alongside of the marginal utility of the money he 
must pay to get them. If there are three things 
equally desired, that is, with the same marginal 
utility for him, he will buy the cheapest because it 
involves the least sacrifice of money, but if the three 
have unequal marginal utilities for him, he will 
probably select the one that has a marginal utility 
most in excess of the marginal utility of the money 
necessary to procure it. It should be obvious that 
the judicious consumer will not make the exchange 
if the marginal utility of the commodity to him is 
not greater than the marginal utility of the money 
he must pay to get it. 

The way in which utility affects price and the re- 
lation of utility and cost to price can be made clear 
by an example. If the cost of growing a peck of one 
vegetable was 45 cents, the huckster might ask 50 
cents for it. The judicious consumer would balance 
the marginal utility of a peck of the vegetable 
against the marginal utility of the 50 cents he would 



PRICE AND DEMAND 61 

have to pay to get it. The marginal utility of 50 
cents would depend upon how much money he had, 
and upon the marginal utility to him of other vege- 
tables of the same price, or even of other foods and 
of other articles. If he thought of many more neces- 
sary or more desirable things he could purchase for 
a half-dollar, he would probably not buy the vege- 
table, particularly if he were not rich, that is, if the 
marginal utility of money was large for him. Other 
richer consumers might buy it, because for them its 
marginal utility would be greater than the marginal 
utility of the money demanded. Presumably the 
price of this vegetable might be put so high that 
only a few would purchase it; in that event, the 
huckster would have to reduce his price in order to 
market all of his product. Thus, not only his cost 
but the marginal utility of the commodity to con- 
sumers collectively would determine his price at any 
one time. If the reduced price gave him no profit, 
he would have to attempt to reduce his cost or stop 
growing the vegetable. If he could reduce cost 
sufficiently, so as to be able to sell at a price below 
the marginal utility of the commodity to consumers, 
collectively considered, he might continue to produce 
at profit. But if he could not reduce cost, he would 
have to curtail production. The curtailment of pro- 
duction would probably increase the marginal utility 
of the vegetable, because marginal utility is deter- 
mined not only by the desirability (value in use) of 
the good but also by the number of units of the 
supply. Thus, the curtailment of the supply would 
increase this vegetable's marginal utility and would 



62 ECONOMICS FOR THE ACCOUNTANT 

enable the huckster to ask a higher price. This 
analysis is merely a restatement of the modus 
operandi of the price mechanism, given in the earlier 
part of this chapter. 

These principles may seem like mere common 
sense, but their relation to prices is often overlooked 
by the accountant, who is immersed in the problems 
of supply and cost. The accountant should be made 
to realize that cost is not the only consideration in 
price making; demand and the marginal utility of 
the commodity to the consumer affect price as defi- 
nitely as cost does. In other words, price is the 
result of a bargain, and it takes two to make a bar- 
gain. The producer's cost is no more important 
than the consumer's marginal utility in the final 
determination of the price to be charged. 

Artificial Stimulation of Demand. — The foregoing 
analysis of the relation of marginal utility and price 
may seem to presuppose that the consumer always 
balances the marginal utilities of the diiferent com- 
modities before he makes a purchase. The ignor- 
ance or carelessness of consumers in balancing the 
different marginal utilities is just as ''uneconom- 
ical" as wasteful or clumsy methods of production. 
One ideal of economics is the greatest possible satis- 
faction of consumers, and it is just as important as 
the other important ideal, the production with the 
least possible effort. Consumers are best off when 
they derive the greatest sum of marginal utilities 
from their expenditures. Obviously, any means that 
would educate the consumer to buy those things, 
which will have high marginal utility for him, and 



PRICE AND DEMAND 63 

not to spend his money on those things that have 
little or no marginal utility for him would be eco- 
nomical. Advertising and salesmanship are methods 
by which the producer attempts to affect the con- 
sumer's psychology. If these selling methods in- 
duce the consumer to buy a rubber heel rather than 
a leather one, and if it can be assumed that a rubber 
heel will come to have a greater utility for the con- 
sumer after he becomes educated to it, they are eco- 
nomically desirable. In so far as advertising is in- 
structive, it helps the consumer to make more 
rational choices. When a new commodity with a 
real utility for the consumer is introduced by either 
of these methods, they may be entirely justified, but 
inasmuch as most advertising and salesmanship are 
calculated to stimulate the producer to buy a par- 
ticular brand, that may be no better and is often 
poorer than some of the other brands, and to buy 
that brand in larger quantities than its marginal 
utility justifies, advertising and salesmanship may 
become interferences with the free play of competi- 
tion and with the consumer's greatest possible satis- 
faction. 



CHAPTER Vn 

t 

PEICE AND THE MEDIUM OF EXCHANGE 

The Marginal Utility of Money. — It has heen ex- 
plained that the price the consumer will pay is deter- 
mined not only by the marginal utility of the com- 
modity he intends to buy but also by the marginal 
utility of the money necessary to make the purchase. 
Money has not the quality of satisfying the con- 
sumer's desires directly, in other words, it has no 
value in use but only value in exchange. The con- 
sumer, before he parts with his money, theoretically 
considers the marginal utilities of all the different 
things that that particular amount of money will 
buy. The marginal utility of a dollar, then, to any 
consumer would probably be somewhat less than the 
marginal utility of the thing purchased with that 
dollar. As the marginal utility of a commodity will 
vary for different consumers according to the num- 
ber of units of the commodity they have consumed 
or acquired, the marginal utility of money will also 
vary according to the amounts they have. 

If a poor man and a rich man were equally hungry, 
the rich man would be able and willing to pay much 
more for a good steak. The poor man might offer 
one dollar whereas the rich man would offer three 
dollars. As it has been assumed that the marginal 
utility of the steak for the two men was equal in 

64 



PRICE AND MEDIUM OF EXCHANGE 65 

this instance, it appears that the marginal utility of 
a dollar was three times as great for the poor man as 
for his richer brother. Apparently the more dollars 
there are, the smaller will be the marginal utility 
of each, and the higher will be prices that consumers 
will pay for goods. The relation between the 
quantity of money in existence and prices will be 
further explained in this chapter. 

On his desert island Crusoe produced all that he 
consumed. There was no need for exchange of com- 
modities. However, if Crusoe and Friday had 
worked independently, Crusoe on certain things and 
Friday on others, they might have exchanged their 
products under some system of barter. If they had 
found that it took either one of them a day of patient 
effort to catch 10 fish and the same expenditure of 
energy to gather five boxes of wild strawberries, a 
box of wild strawberries would probably have ex- 
changed for two fish, provided they were both 
equally as fond of the two products, that is, that the 
marginal utilities of the two foods were equal for 
both of them. It is apparent that in a complicated 
social organization, such as exists to-day, this system 
of barter would be impractical. Producers would 
not be able to estimate with even a practical degree 
of accuracy the relations of their products to the 
many other kinds of products. The other factors 
of production would have to be paid in kind and, 
then, would need to find others who would exchange 
commodities with them. The great difficulties in the 
way of barter for any advanced society would be 
too numerous and too obvious to consider. 



66 ECONOMICS FOR THE ACCOUNTANT 

The Standard of Value and the Medium of Ex- 
change. — If Crusoe and Friday, for the purpose of 
the exchange relation, had reduced all the goods and 
services, which they produced, to a common stand- 
ard such as a fish, they would have been using a fish 
as a standard of value. Then, instead of innumer- 
able exchange relations, such as four boxes of straw- 
berries equal one rabbit, and two rabbits equal one- 
half day's work on the hut, and four boxes of straw- 
berries equal eight fish, and all the other possible 
combinations, there would be just one set of rela- 
tions, one box of strawberries equals two fish; one 
rabbit equals eight fish; one-half day's work on the 
hut equals 16 fish. Although a fish might be used 
as a standard of value, that is, a commodity that can 
be used as a measure for the value of other com- 
modities, it would hardly serve as a medium of ex- 
change, that is, a commodity that can be stored or 
carried around to be given in exchange for other 
commodities. Fish spoil rapidly and they could not 
be carried around. The Indians used wampum; as 
a medium of exchange it was durable, as a standard 
of value it represented to them a very desirable com- 
modity that embodied great satisfactions in small 
bulk. The most primitive people seem to have real- 
ized the need of a medium of exchange that was at 
the same time a standard of value} 

Gold, silver, and other valuable metals are used 

*A good standard of value should be capable of being stored and 
held, so that the total quantity is not much affected by a new year's 
production. Theoretically, this is true of gold, and prices are not 
much affected by the new supply. The general rise in prices since 
1896, however, was largely due to increased gold production. 



PRICE AND MEDIUM OF EXCHANGE 67 

to-day in coin by most of the civilized nations as the 
standards of value and as media of exchange. They 
are universally desired; they represent relatively 
great value in small bulk and thus can be readily 
transported ; they are durable but capable of taking 
a permanent impression ; they can be melted and re- 
divided into a number of parts. These qualities make 
them ideal standards of value or media of exchange. 

There is one difficulty involved in using gold as a 
medium of exchange, and that is in keeping it in cir- 
culation. Gold wears off very rapidly, and gold 
coins are soon worth less in metal than their face 
value would indicate. The United States Govern- 
ment keeps goM and silver in its vaults but prints 
paper money, called gold certificates and silver cer- 
tificates, for every dollar in its possession. These 
certificates circulate and are legal tender, which 
means that the law forces creditors to take them in 
payment of debts. This paper money is economical, 
because it saves the abrasion of the precious metals 
and because it is easier to transport. Although these 
certificates have no value in use, they have value in 
exchange because they are legal tender, because 
there is gold and silver behind them, and because, 
even if there were no actual gold and silver bars in 
the Treasury's vaults, the public has confidence in 
the United States Government's guarantee of their 
value. The greenbacks, which were issued by the 
Government with no deposit of metal dollar for dol- 
lar, circulate as freely as gold or gold certificates. 

Paper Money. — There are other kinds of paper 
money in circulation than those described, but they 



68 ECONOMICS FOR THE ACCOUNTANT 

are banking currency and cannot be understood 
without some knowledge of the banking system. 
Probably the best way to understand the origin of 
banks and banking currency is to consider the early 
goldsmiths of Amsterdam. These goldsmiths not 
only worked on gold but early began to lock it away 
for those who wanted it left in safe-keeping. The 
goldsmith's receipt, given the owner of the gold, 
might very well have been the oldest kind of bank- 
ing currency. If a reliable goldsmith's name had 
become well known, his receipts might have cir- 
culated almost as freely as the gold itself. When 
the goldsmith found that he could issue more re- 
ceipts than were actually covered by the gold in his 
keeping, or the reserve, because all of the holders 
of receipts did not redeem them at one time, he 
began to create banking currency, or credit. This 
is a simplified description of the way in which a 
bank creates banking currency or bank notes. 

The receiving of deposits and the issue of bank- 
notes is only one of the two principal functions of a 
modern bank. The other important function might 
be called the discount function. When a manufac- 
turer has sold goods to a customer, he may receive 
the customer's note rather than cash. If the note is 
not due until some time in the future and the manu- 
facturer needs the money, he can take it to the bank 
and receive the amount of money called for on its 
face minus a discount, which is what the bank exacts 
as a toll for supplying the manufacturer with capital. 
At the maturity of the note the bank collects its face 
value. Discount then is another name for interest. 



PRICE AND MEDIUM OF EXCHANGE 69 

A manufacturer can also borrow from a bank on 
collateral, that is, on stocks or bonds. The bank 
does not actually give the borrower gold or bank 
notes but a credit on its books against which the 
borrower can draw checks. Checks and bank notes, 
then, are the principal media of exchange created by 
the banks, and circulate in the same way metallic 
coins do.^ 

The Quantity Theory of Money. — The quantity of 
the medium of exchange in existence at any one time 
is generally believed to have a definite relation to 
the prices of commodities. If all the owners of goods 
wanted to sell their possessions for metallic cur- 
rency, but on this occasion were willing to part with 
them for all the coins in existence, the prices they 
would receive for their goods would be equal to the 
numbers of dollars, half-dollars, quarters, dimes, 
nickels, and cents given them. If the quantity of 
these dollars were doubled, they would have re- 
ceived prices just twice as great as in the first 
example. If the Indians had found some easy me- 
chanical way of producing wampum, the quantity of 
this medium of exchange would have been increased, 
and, as it increased, its ratio to other things would 
have decreased, that is, other things would have 
been worth more units of wampum or, in our terms, 
would have increased in price.^ 



*ror a lucid and attractive description of the different types of 
money, see Hartley Wither 's The Meaning of Money. 

•A more elementary method of explaining the quantity theory of 
money may be helpful for the beginner. If Friday had caught 10 
fish and had eaten five of them and Crusoe had found five shiny 
pebbles and had his fill of gazing at them, they might have made an 
exchange, had Crusoe wanted the fish and Friday the pebbles. Then, 



70 ECONOMICS FOR THE ACCOUNTANT 

Professor Irving Fisher's work on the quantity 
theory of money is an attempt to give a more 
elaborate analysis of these fundamental principles. 
His exposition of this theory and his statistical 
work on it can be found in his book entitled The 
Purchasing Power of Money (New York, 1911). 
Near the end of Chapter II of his book is the follow- 
ing paragraph : 

In short, the quantity theory asserts that, provided 
velocity of circulation and volume of trade are unchanged, 
if we increase the number of dollars, whether by renaming 
coins, or by debasing coins, or by increasing coinage, or 
by any other means, prices will be increased in the same 
proportion. It is the number, and not the weight, that is 
essential. This fact needs great emphasis. It is a fact 
which differentiates money from all other goods and ex- 
plains the peculiar manner in which its purchasing power 
is related to other goods. Sugar, for instance, has a specific 
desirability dependent on its quantity in pounds. Money 
has no such quality. The value of sugar depends on its 
actual quantity. If the quantity of sugar is changed from 
1,000,000 pounds to 1,000,000 hundred weight, it does not 
follow that a hundred weight will have the value previously 
possessed by a pound. But if money in circulation is 
changed from 1,000,000 units of one weight to 1,000,000 
units of another weight, the value of each unit will remain 
unchanged. 

Price Indices. — The quantity theory maintains 
that variations in the quantity of money normally 
bring about proportional changes in the price level, 

the price of a fish would probably have been one pebble. However, 
had Crusoe found ten pebbles, the price of a fish would have been two 
pebbles. The quantity theory states that prices of commodities vary 
directly with the quantity of money used in exchange. 



PRICE AND MEDIUM OF EXCHANGE 71 

that is, prices as a whole. Thus, inasmuch as the cir- 
culating media in the United States have increased 
since 1890, the general level of prices has increased 
proportionally. Although the prices of some com- 
modities may have risen since 1890, the prices of 
other commodities may have fallen in the same 
period. The price of a bushel of wheat in 1920 may 
be much higher than it was in 1890, but the price of 
a case of canned goods may be lower. Some special 
causes, such as scarcity of farm labor or improved 
methods of canning, may explain the particular price 
movements of these two commodities. The quantity 
theory of money assumes that whatever may be the 
special causes for price changes in any particular 
commodity, the prices of commodities as a whole 
will rise, if the quantity of money is increased and 
will fall, if it is decreased. Therefore, it early oc- 
curred to economists and statisticians that if the 
average of a large number of prices, including the 
prices of all the important commodities, for 1890 
were compared with an average of the prices of the 
same commodities for 1920, it would be possible 
to determine whether prices as a whole had 
risen in the period. A simple average of the prices 
of a bushel of wheat, of a ton of coal, of a paper 
of pins, and of a horse would have given undue 
weight to the coal and the horse. Nor would 
this have been corrected if the number of 
commodities chosen had been very large. However, 
if the prices of all the different commodities in 1890 
had been represented by 100, and if the prices in the 
other years, for which comparison were to be made. 



72 ECONOMICS FOR THE ACCOUNTANT 



had been compared with the 1890 prices and shown 
as percentages of 100, the difficulty, growing out of 
the fact that the sales units of the different com- 
modities, such as wheat and coal, differed in value, 
would have been eliminated. However, it is obvious 
that this method would have given equal weight to 
changes in the prices of wheat, of pins, of coal, and 
of horses. Obviously wheat and coal are more im- 
portant, that is, more widely used, than pins or 
horses. Therefore, weights had to be devised be- 
fore the percentages could be averaged. The weights 
used might be the total sales quantities for the in- 
dustry as a whole, of the commodities, the prices of 
which are being used.'' 

If the prices of only five commodities were being 
used to construct an index of prices (at least one 
hundred or two hundred commodities are needed for 
a reliable index), the procedure might be illustrated 
by the following figures. The prices of the five com- 
modities might have been as follows : 





Com- 


Com- 


Com- 


Com- 


Com- 




modity 


modity 


modity 


modity 


modity 




I 


II 


III 


IV 


v 


1890 


$4.00 


$.04 


$2.00 


$1.00 


$.10 


1900 


4.00 


.01 


2.50 


1.50 


.15 


1910 


6.00 


.02 


4.00 


1.00 


.20 


1920 


6.00 


.04 


4.50 


.50 


.25 



Using the prices of 1890 as a base (100), the rela- 
tive prices for the other years would be as follows : 

* The weights are sometimes obtained from the proportional ex- 
penditures for the different commodities in the family budget. 



PRICE AND MEDIUM OF EXCHANGE 73 





Com- 


Com- 


Com- 


Com- 


Com- 




modity 


modity 


modity 


modity 


modity 




I 


II 


III 


IV 


V 


1890 


100 


100 


100 


100 


100 


1900 


100 


25 


125 


150 


150 


1910 


125 


50 


200 


100 


200 


1920 


150 


100 


225 


50 


250 



If 500,000,000, 2,000,000,000, 400,000,000, 600,- 
000,000, 4,000,000,000 represented the sales in quanti- 
ties in bushels, pounds, or quarts of the five com- 
modities in order, the weights would have been as 
follows: 

Commodity Commodity Commodity Commodity Commodity 
I II III IV V 

5 20 4 6 40 

The relative figures then should be multiplied by 
the weights and averaged, that is, the weighted rel- 
atives should be added and divided by the sum of the 
weights, 75. 



1890. 



1900. 



1910. 



1920. 



Com- 


Com- 


Com- 


Com- 


Com- 


modity 


modity 


modity 


modity 


modity 


I 


II 


III 


IV 


v 



(5 X 100) + (20 X 100) + (4 X 100) + (6 X 100) + (40 X 1 00) 
75 

(5X100) + (20X25) + (4X125) +(6X150) + (40X150) 
75 

(5X125) + (20X50)+(4X200) + (6X100)+(40X200) 
75 

(5X150)+(20X100) + (4X225) + (6X50)+(40X250) 
75 



= 100 



= 112 



= 147 



= 186 



74 ECONOMICS FOR THE ACCOUNTANT 

Therefore, if 1890 be taken as a base year (100), 
the index of prices in 1900 was 112, in 1910 it was 
147, and in 1920 it was 186. According to these 
figures, there appears to have been a general rise in 
prices since 1890, although in 1900 and 1910 the 
price of Commodity II fell and in 1910 and 1920 the 
price of Commidity IV also showed a decrease. 

The Economic Evils of Changing Price Levels. — 
In a period of rising prices, the entrepreneurs reap 
relatively large profits because the amounts they 
have to pay the other factors of production are more 
or less fixed, whereas the prices they receive are con- 
stantly increasing. If laborers are organized they 
can attempt to keep pace by demanding increases in 
wages with every increase in prices, but the capi- 
talist, the bond-holder who lends his money for long 
periods at a fixed rate of interest, and the unorgan- 
ized laborers lose what the entrepreneurs, or the 
stockholders, gain. The way in which an entrepre- 
neur benefits in a period of rising prices can be 
illustrated by a concrete example. The unit costs 
of producing a commodity in two different months 
in such a period might be as follows: 





January- 
Costs per unit 
of product 


June 

Costs per unit 

of product 


Raw materials 


S2.00 
1.00 
1.00 
2.00 


$2.20 


Labor 


1.10 


Interest 


1.00 


Other Expenses 


2.15 








$6.00 


$6.45 



PRICE AND MEDIUM OF EXCHANGE 75 

Assuming prices had increased 10 per cent in tMs 
period as reflected in increased raw material costs, 
if the price in January was $7.00, the price in June 
would have been $7.70. Then, the profit in January 
($7.00— $6.00) would have been only $1.00, whereas 
in June it would have been ($7.70— $6.45) or $1.25. 
Furthermore, if the manufacturer had produced 
goods in January and had not sold them until June, 
the profit would have been $1.70 on every unit. 
Even if the laborers had been well organized and 
had received an increase comparable to the rise in 
the cost of living, as evidenced by the rise in the 
price of this commodity of 10 per cent, the entrepre- 
neur would still have had the advantage of a sta- 
tionary interest rate on long-term investments and 
of selling goods in a market higher than the market 
in which those goods had been produced. If the 
entrepreneur borrowed most of his capital on short- 
term notes from the banks, he might have to pay 
higher interest rates as prices ascended. 

Professor Fisher has proposed stabilizing prices 
by keeping the number of dollars in circulation 
constant. Thus, it is assumed that rising prices are 
due primarily to an increased quantity of the cir- 
culating medium and that if the rise is to be checked, 
the quantity of the medium must be reduced. If 
the number of paper dollars bears a direct relation 
to the number of gold dollars, and as the number of 
gold dollars can be reduced by increasing the num- 
ber of grains of gold in a dollar, the total quantity 
of money can be regulated at will, and prices can be 
automatically adjusted. Although it seems true that 



76 ECONOMICS FOR THE ACCOUNTANT 

the most important factor in explaining the long- 
time fluctuations in the price level is the change in 
the quantity of money, the quantity of paper money 
is as important as the quantity of gold and there is 
reason to believe that the quantity of paper money 
does not always bear so fixed a relation to the 
quantity of gold as the quantity theorists have some- 
times been in the habit of assuming. However, a 
number of economists have come to believe that 
some regulation of the quantity of money in circula- 
tion, whether by the stabilization of the dollar or 
otherwise, is necessary in order to control unneces- 
sary fluctuations in the price level 



CHAPTER Vin 

ECONOMIC COST AND ACCOUNTING COST 

Economic Costs.— Cost may be defined as the sac- 
rifices or expenditures made in the process of ob- 
taining satisfactions or accomplishing ends. Thus, 
the costs of war include human lives, expenditures 
for munitions, as well as other sacrifices and losses 
that are harder to measure. As man's efforts to 
make a living constitute the economist's problem, it 
is obvious that the analysis of these efforts or costs 
is a large part of economic science. To the positive 
efforts spent in production must be added the nega- 
tive sacrifices in order to measure the total human 
costs of production. These human costs include all 
the labor, physical and mental, and all the sacrifices 
expended in producing goods and services. It has 
been explained in the preceding chapter that the 
productive process requires the services of laborers 
and probably of entrepreneurs together with the 
sacrifices or postponements of capitalists. All the 
physical exertions with the attendant fatigue and all 
the mental discomfort expended in production con- 
stitute the human costs or sacrifices. Nothing could 
be produced without some waste of energy, fatigue, 
and postponement of pleasure. These human costs 
include many elements that are difficult or impossi- 
ble to measure in monetary terms. 

77 



78 ECONOMICS FOR THE ACCOUNTANT 

Society's negative as well as positive exertions 
might be measured in pain units, and human costs 
may be designated sacrifice or pain costs.^ If the 
pain or sacrifice units could be standardized for all 
those who aid in production, each unit might be 
given the value 5. One laborer might exert 1,000 
units of s in the same time and with the same effect 
that another laborer would exert 2,000 of the same 
units. Thus, 1,000 s would be the sacrifice cost of 
the first laborer whereas 2,000 s would represent the 
sacrifice cost of the second laborer for the same 
quantity of product, or p. If it took x units of s to 
produce all commodities, p, then, 

xs is the cost of p 

The sacrifice or pain cost of production, xs, could 
be kept stationary or decreased while the total 
quantity of product, p, might at the same time in- 
crease. This could be accomplished by a more effec- 
tive application of the sacrifices expended. Obvi- 
ously, it is the goal of economics to reduce xs as much 
as possible, and, in so far as more goods and services 
are needed, it is desirable to increase p at the same 
time. If xs were expended ineffectively, xs minus ys, 
or zs, might have been all the cost necessary to pro- 
duce p, where ys represents all the pain units that 
were needlessly sacrificed, and where zs represents 
the least possible cost. The economist often considers 
the loss due to the ineffective application of sacri- 
fice as the sacrifice cost ; in terms of sa'crifice or pain 

* Where the capitalist has so much, the sacrifice in saving may be 
negligible, but this may also be true of the laborer who loves hia 
work. 



ECONOMIC AND ACCOUNTING COST 79 

units, this cost would be ys. Although this might be 
considered loss or waste, it does not constitute the 
entire sacrifice cost and is only a part of it. This 
can be demonstrated in mathematical terms as fol- 
lows: 

As long as some sacrifice or pain will probably 
always be involved in production, zs, the least pos- 
sible cost, will always be a positive quantity, and 
xs minus ys equals zs. Then, xs will be greater than 
ys, and the entire sacrifice cost will be greater than 
the sacrifice needlessly expended. 

Although the conception of cost that has been 
presented is the concern of the economist, many of 
the elements of this sacrifice cost cannot be measured 
accurately in money. Economic science, inasmuch as 
it treats of a monetary or price system, usually at- 
tempts to apply the monetary or numerical measure 
to its concepts. Many sacrifice costs cannot be com- 
puted accurately but are reflected, neverthless, in 
money values. The undertaker's possible repulsion 
to his work cannot be measured by him in monetary 
terms and should probably not be included as one 
of his costs; however, in so far as the disagreeable- 
ness of the work reduces the number of competitors 
who enter the field, it probably increases the profit 
of those who are willing to follow this vocation.* 

The concept of sacrifice cost is sometimes made 
even more embracing. Loss by fire and the con- 
sumption of goods might be counted as costs to be 
added to the costs involved in the production of the 
goods burned or consumed. But it should be obvious 

' See page 140 where the relation of risk to profit is discussed. 



80 ECONOMICS FOR THE ACCOUNTANT 

that consumption is accomplishment, the end of 
cost, and that even though loss by lire might be con- 
sidered a social loss, it could not be called a cost of 
production. Depreciation, too, may seem to be an 
economic cost, but the analysis of this item, which 
is to be given later, will show that although it can be 
reduced to economic cost, it should not be added in 
with the subjective human, or sacrifice, costs because 
such procedure would involve a duplication, that is, 
adding twice the human costs involved in the pro- 
duction of the fixed capital goods depreciated.^ 

Money Costs. — The economic concept of cost is 
puzzling to the average man because he always 
thinks of cost in terms of money. To him, the cost 
of labor is what the laborers are given in money 
wages. He thinks of wages, interest, rent, profit, 
depreciation, and taxes, as the costs of production. 
Marshall would, perhaps, call these the expenses of 
production, but there is nothing to be gained by this 
terminology.^ It is clear that the sum total of wages, 
interest, rent, and profit equal the sum total of all of 
the prices paid by all consumers; therefore, the ag- 
gregate of these money shares might be called the 
consumer's cost of production. It represents the 
money demanded from the consumer by the factors 
of production; it is, therefore, the consumer's cost, 
or what he has to sacrifice to gratify his desires. 
There is another conception of consumer's cost that 
should be considered here. Many economists who 
realize that consumption and the consumer are prob- 

•See page 110. 

* Alfred Marshall, Principles of Economics, p. 418. 



ECONOMIC AND ACCOUNTING COST 81 

ably the principal interest of economics believe that 
society and the consumer is best served when prices 
are as low as possible. However, if the price of a 
commodity in any period were too far below costs, 
some companies might fail and production would 
certainly be curtailed. In that event, prices might 
subsequently rise and the consumer would have to 
pay more for his satisfactions because he had ob- 
tained them at too low a price in the past. Thus, 
the consumer's ultimate cost is not merely present 
price but an average of both present and future 
prices. 

Accounting Cost and Entrepreneur's Cost. — ^In all 
that has been said about cost, no mention has been 
made of cost, as the accountant defines it. Although 
the accountant's cost is neither the sacrifice 
cost nor the consumer's cost, these broader con- 
ceptions must be grasped before the accountant's 
practical interpretation of them can be properly 
understood. The accountant is not keeping books 
for society or for the consumer; he keeps his accounts 
for the entrepreneur, in a corporation the common 
stockholders, for whom he is a hired laborer.^ The 
entrepreneurs have little or no interest in society's 
costs or sacrifices ; they are merely interested in what 
they have to expend and sacrifice in order to ac- 
complish their ends, namely, production and the 
earning of profit. Their expenditures include the 
raw materials used, the wastage of fixed capital 
goods, what has to be paid the other factors of pro- 

'The prineipal purposes of the accountant's itemized cost were 
discussed on page 16 in Chapter II ; they are set forth compactly, 
however, in Appendix I. 



82 ECONOMICS FOR THE ACCOUNTANT 

duction, and what is taken by the state. In this re- 
spect, their costs are identical with the consumer's 
cost, except that the consumer 's expenditures include 
the entrepreneur's profit, whereas the entrepreneurs 
naturally exclude their own remuneration.® 

Theoretically, accounting cost should include 
every item of price except the profit claimed by the 
entrepreneur. It will be shown, however, that some 
of the elements of price cannot be included in ac- 
counting cost for practical reasons. Some elements 
of price, which the entrepreneur does not receive, 
such as the income tax (page 193), donations (page 
190), as well as bad debts'' and cash discounts on 
sales,^ which might be considered as elements of 
gross selling price, cannot be included in accounting 
cost. Accounting cost might be defined as all the 
entrepreneur's necessary expenditures or sacrifices 
in production, which are not dependent upon the 
consumation of the sale of the product. The full 
significance of this definition will be grasped after 
reading the next two chapters, the discussion of the 
tax on profits as a part of cost, and Appendix II. 

Entrepreneur's cost is often thought of as merely 
the money disbursements that the entrepreneur 
makes to persons other than himself. The fallacy 
in this idea should be immediately evident. When 
a person or group of persons embodies the entrepre- 
neurial functions, that fact does not preclude the 
same person or persons from embodying the function 
of one or more of the other factors of production. 

• See Appendix II. 

* See Appendix II. 



ECONOMIC AND ACCOUNTING COST 83 

The classic shoe repairer, who had accumulated the 
capital necessary for the purchase of his capital 
goods, who hired no laborer, had practically no costs 
if money disbursements to the other factors of pro- 
duction are the only costs.^ The shoe repairer may 
have thought of his receipts as all profit, but careful 
analysis would have shown him that they came to 
him not only as entrepreneur, but also as capitalist- 
laborer, and that they were for that reason not only 
profit but interest on his invested capital and wages 
for his labor. If A embodies the functions of laborer, 
entrepreneur, and capitalist, he should be thought 
of as a different economic person in each capacity : as 
entrepreneur, he would be Ai; as laborer, Az; as 
capitalist, A3. Then Ai, entrepreneur, owes A2 and 
As wages and interest respectively if A is not only 
entrepreneur but laborer and capitalist as well. 
Entrepreneur's cost, then, is consumer's cost, that 
is price, minus the profit of the entrepreneur for 
whom the cost computation is being made. Just as 
the consumer's costs represent the consumer's sacri- 
fices, or payments in order to consume, so the entre- 
preneur's cost represents his sacrifices, be they his 
money expenditures to others, his own work, or any 
other sacrifices he may make in his other economic 
capacities. The money the entrepreneur has to pay 
to others, the wages that he owes himself as laborer, 
and the interest that he owes himself as capitalist 
should all be included in his cost. It might be asked 
whether the undertaker's repulsion is a part of his 

* His raw material costs, probably included in overhead, and taxes, 
however, were actual disbursements. 



84 ECONOMICS FOR THE ACCOUNTANT 

cost. This repulsion is a sacrifice of the entrepre- 
neur, as entrepreneur, and not as laborer or capi- 
talist. Whatever he is paid for overcoming his re- 
pulsion is reflected in a higher rate of profit. 

Most accountants maintain that the pure entre- 
preneur's cost is not the cost that they are attempt- 
ing to determine. They note that the entrepreneur 
in most business organizations usually owns a part 
of the capital. Therefore, they feel that they are 
computing a cost for their employer as capitalist as 
well as for their employer as entrepreneur. This 
problem will be discussed in Chapter X and in Ap- 
pendix I. The entrepreneur's cost, which may or 
may not be in the proper conception of cost for the 
accountant, is the consumer's cost minus the profit 
of the entrepreneur for whom the cost computation 
is being made. It was not stated, however, that the 
entrepreneur's cost is the consumer's cost minus all 
profit or that it is merely wages, rent, and interest. 
As a matter of fact, any one entrepreneur's cost in- 
cludes some profit. Practically every entrepreneur 
has to buy raw materials from which to manufacture 
his finished product. What he pays for this raw 
material is divided between the laborers, the land- 
owners, the capitalists, and the entrepreneur of the 
company from which he purchased. Thus, the raw 
material cost of one entrepreneur represents em- 
bodied wages, rent, and interest, together with 
profits to entrepreneurs, who were concerned with 
earlier stages of production. 

It might occur to the accountant that the Cost ac- 
count contains many items other than wages, rent, 



ECONOMIC AND ACCOUNTING COST 85 

and interest; in fact, some might only identify wages. 
It will be shown in the next chapter, however, that 
all of the items of the Cost account, Kaw Materials, 
Materials and Supplies, Maintenance and Repairs, 
Light, Heat, Power, Depreciation, Depletion, and the 
other items of Overhead, can be analyzed into the 
economic categories already described. 

Theoretically, the total receipts of the entrepre- 
neur. Sales, representing an aggregate of prices paid 
by the consumers, are distributed through him to 
the other factors of production. As a matter of fact, 
however, the entrepreneur has to make many dis- 
bursements before his goods are sold and his sales 
receipts obtained. This is made possible by the use 
of the capital loaned him by the capitalist. Thus, 
capital not only enables the producer to obtain the 
fixed capital goods necessary in production, but it 
supplies him with the means of paying his costs, 
raw materials, interest, rent, and wages, before he 
realizes anything from the sale of his finished 
products. 



CHAPTER IX 

THE ELEMENTS OF ACCOUNTING COST 

In this chapter accounting cost and the items that 
compose it will be considered. If the accountant is 
determining the cost of producing a certain quantity 
of flour, which was manufacturred in a definite 
period, he should include all the expenditures and 
economic sacrifices of the flour miller that went to 
produce that particular quantity of flour, but he 
should not include the entire cost of the machinery 
or of any other kind of capital goods that were ex- 
pected to last longer than the stated period of pro- 
duction. The depreciation on these fixed capital 
goods, or that portion of the fixed capital goods that 
is used up, however, is a part of his cost.^ 

Thus, as was explained in the last part of Chapter 
VIII, the accountant conceives of the capital ob- 
tained by the entrepreneur as flowing off into two 
separate streams: (1) into current expenses or costs 
of production, such as wages, interest, rent, and raw 
materials; (2) into fixed investment, such as build- 
ings, machinery, land, which is supposed to last for 
many production periods. 

The main subdivisions of accounting cost for a 
manufacturing establishment, where cost accounting 

» See Chapter X. 



ELEMENTS OF ACCOUNTING COST 87 

is most necessary,^ are Kaw Materials, Labor, Fac- 
tory Overhead, including Rent actually paid. Gen- 
eral and Administrative Expense, Selling Expense, 
and Depreciation. There is considerable debate 
about Interest. The first two items are often called 
prime costs, and theoretically can be separated so 
that each of the finished products can be made to 
bear the exactly correct parts of these items that are 
attributable to it. The next two items are sometimes 
grouped together and called Overhead, but when 
there are a number of factories distinct from the 
general office, this separation is valuable. The dis- 
tinction between prime cost and overhead lies in the 
fact that the overhead has to be spread over the 
entire product according to some estimate and can- 
not be distributed to each part thereof on so accurate 
a basis.' Selling Expense applies to the goods sold 
and not to those produced, and when there are widely 
differing inventories, output and sales will be very 
different. Depreciation on the capital goods of the 
factory is often considered a part of Factory Over- 
head, and depreciation on the fixtures and furniture 
of the general office is generally included in General 
and Administrative Expense. The much discussed 
question regarding Interest as a cost item will be 
presented in Chapter X and Appendix I. 

Raw Materials. — The first item in the manufac- 
turer's cost is Raw Materials. The refiner must have 
his crude oil; the meat-packer must have his cattle; 

' See Chapter II, page 15. 

* There is another important distinction between prime costs and 
overhead (see page 157). 



88 ECONOMICS FOR THE ACCOUNTANT 

the tomato canner must have his raw tomatoes. The 
exact amounts of money spent for these raw 
materials represent the Raw-Material costs of the 
respective producers. If the tomatoes had to be 
hauled to the cannery, the hauling or collecting 
expense might well be included in the Raw-Material, 
or tomato, cost. If some of the tomatoes were 
spoiled, and if the canner were granted a certain 
allowance, the amount thereof would be deducted 
from his cost. It has already been pointed out in the 
last chapter on page 84 that the Raw-Material cost 
represents embodied wages, rent, interest, and profit. 
The canner 's cost of tomatoes represents the prices 
paid therefor, that is, the wages paid to farm hands, 
the rent paid to landlords, interest paid to the banks, 
and profit surrendered the farmer. 

A difficulty arises when the producer also manu- 
factures his raw material. The refiner quite com- 
monly owns the company that produces the crude 
oil. The accountant insists that the refiner include 
all crude oil at the actual cost thereof and that the 
crude oil should not be transferred from the produc- 
ing company to the refining company at market 
prices, which might thereby introduce a profit to 
the refiner into his cost.* When the refiner com- 
plains that this procedure would allow his competi- 
tors, who buy their crude oil, to show a higher Raw- 
Material cost, because it would include the profit on 
crude oil paid the crude producers, the accountant 

*In the trade, the crude oil producers are called "producers." As 
a matter of fact, from the economic point of view, they are no more 
producers than the refiners are (see page 20). 



ELEMENTS OF ACCOUNTING COST 89 

answers that such refiners have higher costs.'' Their 
oil costs are higher because their production unit is 
not so complete. The refiner who obtains more capi- 
tal and who can produce his own crude oil will have 
a lower cost just as the large shoe factory with a 
large amount of machinery will probably produce 
more cheaply than the small shoe factory with little 
machinery. The refiner who produces his own crude 
oil might also be answered by being told that, 
whereas his competitors have higher material costs, 
he has a compensation in a larger investment, that 
is, the investment in producing as well as in refining, 
on which to calculate interest or to measure gross 
profit — economic interest and profit. Obviously, 
the refiner must realize that allowing a profit on 
crude oil in his cost would be no different from 
allowing a profit on the oil, left after the gasoline 
process had been completed, in computing the cost 
of a heavier product, such as fuel oil. Or, to take a 
simpler example, the pie maker who makes his own 
preserves would not include a profit on preserves 
when he was computing the raw material cost of his 
pies. All of the processes necessary for the com- 
pleted pie or for the refined petroleum products 
should be treated as one operation and no interde- 
partmental or intercompany profits should be al- 
lowed. 

It might appear that in certain extractive and 
genetic industries there is no Eaw-Material cost. A 

' The refiner would only make such a complaint when he is thinking 
of the Income Tax or price fixing; a producer always wants to have 
low costs even though he might not want them to appear so. 



90 ECONOMICS FOR THE ACCOUNTANT 

farmer only needs to buy seeds, and for some crops 
it is conceivable that he would not even have a seed 
cost. A man might rent a field merely for its uncul- 
tivated field mushrooms. If he picked them and 
marketed them, he would be conducting an economic 
organization but would apparently have no cost of 
Eaw Materials. As a matter of fact, he would prob- 
ably have to pay a higher rent because of the mush- 
rooms. In that event a part of what he called rent 
would actually have been Eaw-Material cost. The 
farmer's Eaw-Material cost, for the same reason, 
might be considered to include not only the cost of 
the seeds, but also the rent paid for the use of the 
soil. The difference between this kind of rent and 
pure location rent will be explained in the next para- 
graph. 

The Eaw-Material cost in copper mining or in 
crude oil producing is the payment made for the use 
of the land under which operations are being carried 
on. If the producers have to purchase a lease, the 
accountant might tell them to take the actual cost 
of the lease and divide it by the number of periods 
of anticipated production in order to determine the 
Depletion cost for each period. This Depletion cost 
is similar to Eaw-Material cost. If the supply is not 
"depleted" in equal proportions in each year, the 
Depletion is charged in each period according to the 
quantity withdrawn. Probably the best metliod of 
charging Depletion can be illustrated by an example. 
If a producer of crude oil had to pay $200,000 for the 
lease of a piece of land that the geologists estimated 
would yield 100,000 barrels over a period of 10 years, 



ELEMENTS OF ACCOUNTING COST 91 

the Depletion per barrel would be $2. Then, if 
10,000 barrels were '"lifted" in the first year, the 
Depletion charged to cost would be $20,000, but if 
20,000 barrels were taken out, the Depletion would be 
charged at $40,000. However, the fact that the first 
year's flow was larger than might have been 
expected may have resulted in a revision of the 
estimated number of barrels in the deposit to 200,- 
000 barrels; in that event the Depletion per barrel 
would have been $1, and the first year's charge 
$20,000. The oil producer often has to pay a yearly 
rental in addition to what he pays for the lease. 
There are, then, two kinds of rent: one kind is paid 
for a location, that is, a convenient place on which 
to produce; the other kind is paid for the actual 
properties of the soil and is largely material cost 
and not mere location rent. 

Wages. — The second important item of the ac- 
countant's cost is what he calls Labor, for which 
wages would be a more logical title. This item is 
often called Direct Labor and is supposed to include 
the wages of the laborers who work directly on the 
product. The wages of the carpenters and other 
laborers who work in the plant but not directly on 
the product are often included in Indirect Labor. The 
Factory Superintendent's Salary is not usually con- 
sidered a part of either item and is regularly classed 
with Overhead. The sum of the Direct Labor, the 
Indirect Labor, and the Factory Superintendent's 
Salary will ordinarily constitute the total factory 
payroll. 

The economist takes little interest in most of these 



92 ECONOMICS FOR THE ACCOUNTANT 

classifications; to him all those who work for a fixe'd 
wage or salary, be they factory hands, administra- 
tive clerks, or railroad presidents, are laborers and 
their remunerations are all called wages. The econ- 
omist would even include the wage element in raw 
materials as a part of the total wage distributions of 
the entrepreneur. When the wage earners receive 
bonuses depending upon the entrepreneur's profit 
or are actually working under a profit-sharing 
scheme, a part of their wages represents a share of 
profits. Although the wages of the factory workers 
are classed with the administrative salaries by the 
economist, the accountant's classification has some 
economic interest. The factory workers give their 
attention to "production," that is to supply; the 
administrative force and the salesmen are very often 
primarily interested in marketing, that is, demand. 
The administrative force undoubtedly gives a great 
deal of attention to "production," in fact more than 
many accountants seem to realize ; but the sales force 
is almost entirely interested in stimulating demand." 
It should be noted that "production" is used here in 
the accounting but not in the economic sense. 
Marketing is a part of production, according to the 
economist. 

Overhead. — Most of the items of Overhead can be 
analyzed into labor and materials, and, therefore, 
back into wages, interest, rent, and profit. This is 

• The belief that the administrative force gives most of its time to 
selling rather than to * ' production, ' ' in the accounting sense of * ' pro- 
duction, " has led to the classification of General and Administrative 
Expense with Selling Expense rather than with the manufacturing 
costs (see Chapter II, page 15). 



ELEMENTS OF ACCOUNTING COST 93 

true of Maintenance and Eepairs and of Materials 
and Supplies. Light, Heat, and Power can be 
analyzed into the same elements as Eaw Materials. 
The payments to the electric company represent the 
wages, interest, rent, and profit of the electric com- 
pany's Profit and Loss account. Eent, Depreciation, 
and Taxes, which are usually included in Overhead, 
will be discussed in the next chapter and in Chapter 
XIV. The General and Administrative Expense 
includes one item of especial interest, the entre- 
preneur's salary for actual services rendered. This 
also will be discussed in the next chapter. 

It is clear that the accountant's classification of 
the items of cost has but little connection with the 
economist's classification. The accountant is con- 
cerned with the way in which the entrepreneur 
spends his money and with the best method by which 
these expenses can be allocated to the different 
products produced. He sometimes even classifies 
the items of cost by the processes involved in manu- 
facturing the product. Nevertheless, the account- 
ant's cost could always be analyzed into the econ- 
omist's categories of wages, interest, rent, and 
profit were it worth the trouble and expense. 

If the purposes of the accountant's cost be con- 
sidered, his classification of items will be more under- 
standable. It has already been explained that the 
accountant uses cost as a basis of price and that he, 
therefore, attempts to find the exact amount of 
expense that should be charged to each unit of 
product.'^ One of the accountant's most important 

^ See page 16. 



94 ECONOMICS FOR THE ACCOUNTANT 

problems is the allocation of the items of expense to 
the different products manufactured when a num- 
ber of products are produced at the same time. The 
students of cost accounting have devised elaborate 
systems for segregating Overhead in order to find 
the units costs.* The problems of expense distribu- 
tion must be solved by the accountant and the indus- 
trial engineer, but there are certain principles that 
the economist should announce and which the ac- 
countant must take heed of, especially in co-product 
and joint-product accounting. 

Joint Costs. — ^Before considering these principles, 
it is necessary to establish arbitrarily certain dis- 
tinctions in terminology. If two or more products 
are made from the same raw material, they may be 
called either joint-products or co-products. Joint- 
products may be defined as products taken off at the 
same time. Moreover, one of the joint-products can- 
not be produced without the other. Butter and but- 
termilk are good examples of joint-products, be- 
cause butter cannot be produced without the joint- 
production of buttermilk. Co-products are pro- 
duced from the same raw material, but they are not 
necessarily produced simultaneously. Furthermore, 
only one of the co-products must be produced; the 
others need not be considered if there is no profit 
anticipated. For example, after gasoline is taken 
from crude oil, the other co-products, kerosene, fuel 
oil, gas oil, etc., can be manufactured, or the crude 
oil remaining after the extraction of the gasoline 

* The total costs divided by the total production gives the unit cost. 
(See Chapter II.) 



ELEMENTS OF ACCOUNTING COST 95 

could be thrown away if there were no good market 
for kerosene, fuel oil, and the other co-products. 
Two or more joint-products might be main products 
or one or more of them might be by-products, accord- 
ing to which of the different products were the most 
important. Thus, if a butter producer were little 
interested in buttermilk and merely fed it to the 
hogs, butter would be his main product and butter- 
milk merely a by-product. However, if his butter 
business were no more important than his butter- 
milk business, they would both be main products.^ 
For certain dairies, presumably, buttermilk might 
be a main product and butter only a by-product. All 
of the co-products from one raw material might be 
main products or all but one might be by-products. 
In accounting for co-products, produced from the 
same raw material but produced independently, 
there is one obvious principle to be considered. Any 
method of cost accounting that year after year 
results in a loss on one co-product for all manufac- 
turers in a trade should be suspected. Thus, it 
would probably be erroneous cost accounting to show 
a loss year after year on kerosene, if the trade con- 
tinued to produce it. If a tomato canner who had 
been throwing away his cores, skins, and small fruit 
began to use such waste for making pulp and catsup, 
he would not continue to make these co-products, 
which would probably also be by-products, if the 
price received did not at least cover the cost. Labor 

• If buttermilk became the main product, it would probably not be 
because of the churned buttermilk but rather because of the cultured 
skim milk. 



96 ECONOMICS FOR THE ACCOUNTANT 

and Overhead, of making up the pnlp and catsup. If 
the prices received just covered the manufacturing 
costs, there would be no possibility of allocating a 
part of the tomato, or Raw-Material, cost to pulp and 
catsup. It might seem, therefore, that the pulp and 
catsup would have no Raw-Material cost. However, 
this would not necessarily be true. Practically, 
there would be three different possibilities: (1) if 
the sales realizations from the co-product did. not 
cover the Labor and Overhead costs specifically 
needed in the manufacture of the co-product, no part 
of the Raw-Material cost of the principal co-product, 
or main product, could be allocated to the subsidiary 
co-product, or by-product ; then obviously the manu- 
facture of such a by-product would be unprofitable 
and would not be continued; (2) if the sales realiza- 
tions from the co-product just barely covered the 
Labor and Overhead necessary in the production 
thereof, it would be impossible to charge much of the 
Raw-Material cost to such a co-product; (3) if the 
sales realizations on the co-product amply covered 
its Labor and Overhead costs, it would be necessary 
to allocate part of the Raw-Material cost to the co- 
product. Obviously, much would depend on what 
was in the producer's mind when he purchased the 
raw material. The question arises as to the method 
of allocating the Raw-Material cost to the different 
co-products. 

If to the pulp and catsup there was allocated no 
part of the Raw-Material, or tomato, cost, and but 
little overhead and labor were necessary in the pro- 
duction of pulp and catsup, the pulp would show a 



ELEMENTS OF ACCOUNTING COST 97 

negligible cost and a large profit. The accountant, 
therefore, might he led to believe that the tomato, 
or Eaw-Material, cost should be divided between 
canned tomatoes and pulp on the basis of weight, 
that is, if the cores, skins, and small fruit weighed 
one-eighth as much as the fruit that was canned, 
one-ninth of total cost of the fresh tomatoes should 
be allocated to the pulp and eight-ninths to the 
canned tomatoes. This method of allocation, which 
implies that a pound of cores and skins are as costly 
as a pound of the fruit itself, might consistently 
show a loss on the pulp and, thus, would violate the 
principle already announced. 

It is evident that when the tomato canner is also 
a pulp manufacturer, he buys two distinct products 
when he buys his fresh vegetables; he is buying 
tomatoes for canning and cores and skins for pulp. 
If his most profitable line were canned tomatoes, he 
would attempt to buy large tomatoes so as to have a 
relatively small waste from cores, skins, and small 
fruit. However, if pulp or catsup brought a good 
price, he would not take such pains to avoid a crop 
from which "waste" of this kind could be secured. 
Obviously, catsup and pulp might become main 
products, after having been by-products. Since such 
considerations should, and must, enter the manu- 
facturer's head, it is evident that he is paying two 
different prices for the two raw materials and that 
these prices bear a definite relation to the market 
values of the co-products manufactured therefrom. 
Thus, it might seem that if his total pack of canned 
tomatoes brought four times as much as his pack of 



98 



ECONOMICS FOR THE ACCOUNTANT 



pulp and catsup, he should allocate four-fifths of his 
Raw-Material cost to canned tomatoes and one-fifth 
to pulp. However, a practical example will show the 
difficulty involved in this method of allocation. 

If the Raw-Material cost per unit for two co- 
products was $3.00 and the sales realizations from 
co-product No. 1 was $4.00 and that from co-product 
No. 2 was $2.00, it might seem that 



4.00 



4.00+2.00 



or Vi 



of $3.00, that is, $2.00, should have been charged as 
Raw-Material cost to co-product No. 1 and Ys of $3.00, 
or $1.00, should have been charged as Raw-Material 
cost to co-product No. 2. However, if it had cost 
$1.20 to manufacture co-product No. 1 and $1.10 
to manufacture co-product No. 2, the Profit and 
Loss account would have been approximately as 
follows : 





Co-product 
No. 1 


Co-product 
No. 2 


Sales 


$4.00 


$2 00 






Raw-Material Cost 


$2.00 
$1.20 


$1 00 


Manufacturing Cost 


$1 10 






Total Cost 


$3.20 
$0.80 


$2.10 


Profit and Loss 


$0.10 







Thus, this method of allocation would have in- 
volved a loss on co-product No. 2 because it would 



ELEMENTS OF ACCOUNTING COST 99 

have charged it with too much Eaw-Material cost. 
If this co-product were a by-product, it might seem 
that the manufacturer should have discontinued pro- 
ducing it. However, if he had discontinued produc- 
ing it, he would have lost even more. Although he 
lost $0.10 on co-product No. 2, he made $0.80 on 
co-product No. 1, or $0.70 in all. If he had discon- 
tinued producing co-product No. 2, the following 
would have been the showing of his Profit and Loss 
account : 

Sales, Co-product No. 1 $4.00 

Raw Material Cost $3.00 

[If No. 2 is not produced, all has to be charged to No. 1.] 

Manufacturing Cost 1 . 20 

[Manufacturing Cost of No. 2 has no longer to be considered] 

Total Cost, Co-product No.l $4.20 

Loss $0.20 

Therefore, it was better to have produced co- 
product No. 2 than to have thrown away the raw- 
material left after co-product No. 1 had been manu- 
factured. However, the method of allocation used 
was obviously faulty because it violated the principle 
announced. As long as the sales realizations from 
co-product No. 2 more than covered the manufactur- 
ing cost of that co-product, it was economical to 
produce it. From the sales the fixed manufacturing 
cost might be deducted and the Eaw-Material cost 
might be allocated to the two co-products on the 
basis of the remainders, that is, Eaw-Material cost 
plus Profit. 



100 ECONOMICS FOR THE ACCOUNTANT 





Co-product 
No. 1 


Co-product 

No. 2 


Sales 


$4.00 
1.20 


$2.00 


Deduct Manufacturing Cost 


1.10 


Remainder 


$2.80 


$0.90 







Then, 



2.80 



2.80-1-90 



2.80 
3.70 



-.75 



75 per cent of $3.00, the Eaw-Material cost, or $2.25, 
might be allocated to co-product No. 1 and $3.00 — 
$2.25 or $0.75 to co-product No. 2. 





Co-product 
No. 1 


Co-product 
No. 2 


Sales 


$4.00 


$2.00 






Raw-Material Cost 


$2.25 
1.20 


$0.75 


Manufacturing Cost 


1.10 






Total Cost 


$3.45 


$1.85 






Profit 


$0.55 


$0.15 







This method of allocation may seem to introduce 
market values into cost, the hete noir of the account- 
ant. However, the total costs are included as costs 
with no element of profit, and only the fractions 
used in the division of the material costs between 
the two products are based on market values. The 
refiner should use this method of distributing the 



ELEMENTS OF ACCOUNTING COST 101 

cost of crude oil between the different petroleum 
products. Thus, he should determine the sales real- 
izations from gasoline, kerosene, and fuel oil to be 
obtained from a barrel of crude oil, and the method 
outlined should be used for dividing the total Eaw- 
Material cost between the different refined products. 
This allocation of material cost would be useless if 
the refiner did not keep an accurate record of the 
costs of the processes used in taking off the various 
co-products. 

Accurate records of the costs of the various proc- 
esses involved in the production of co-products, such 
as canned tomatoes, pulp and catsup, or gasoline, 
kerosene, fuel oil, etc., may be possible, but such 
segregations are obviously not practicable in joint- 
product cost accounting. For example, when butter 
is produced, buttermilk automatically comes into 
existence. Even if it were reasonable to divide the 
total fresh-milk, or butterf at, cost between the butter 
and the buttermilk merely on the basis of the sales 
realizations, it would be obviously impossible to 
determine what parts of the total Labor costs and 
Overhead costs should be allocated to the two 
products when they are both manufactured by the 
same process. The accountant's method of placing 
all the cost on the principal joint-product, butter, 
and of deducting the sales of the by-product, butter- 
milk, assumes that all the buttermilk costs, includ- 
ing the buttermilk profit, should be separated from 
the butter costs by means of the ratio of the selling 
prices of the two products. 

The following example will show how the method 



102 ECONOMICS FOR THE ACCOUNTANT 

of crediting the sales of the by-product practically 
corresponds to a division of cost between the main 
product and the by-product on the basis of sales. 

Assume the cost of cream necessary to make one 
pound of butter were $0.71, and that on the basis of 
sales $0.70 could be charged to the pound of butter 
and $0.01 to buttermilk. Furthermore, assume that 
by some stretch of the imagination, it would be pos- 
sible to separate the operating costs of making but- 
ter from the operating costs of making buttermilk; 
if the reader has no such imagination, a separation 
could be made on the basis of sales. Then, the costs 
might be as follows: 



Costs 


Butter, 
1 pound 


Buttermilk,* 
1| pounds 


Raw Material (Cream) 


$0.70 
.04 


$0.0100 


Other 


.0025 






Total 


.74 


.0125 






Price 


$0.77 
.74 


$0.0150 


Total Cost 


.0125 






Profit 


.03 


.0025 







*It is assumed that the skim milk was kept by the farmer. 

Obviously such a method of allocation would not 
be possible because it would involve a most uncon- 
vincing allocation of the operating costs of the two 
joint-products. Therefore, the accountant places all 
the cost on the main product, butter, and credits the 
sale of the by-product in the following way: 



ELEMENTS OF ACCOUNTING COST 103 

Total Cost of Raw Material (Butter and Buttermilk) $0.7100 

Total Operating Cost (Butter and Buttermilk) 0425 

Total Cost $0.7525 

Credit Selling Price of 1| pounds Buttermilk 0150 

Net Cost of Butter $0.7375 

It should be apparent that whereas in the first 
method shown the items of cost were allocated to the 
two joint-products, in this method the crediting of 
the selling price of the by-product is really an 
attempt to subtract from the total costs the approxi- 
mate buttermilk costs on the assumption that the 
buttermilk price will bear a close relation to the 
buttermilk cost. This method of crediting the sale 
of the by-product includes a profit on the buttermilk 
in the deduction and, therefore, reduces the butter 
cost by the amount of such profit. In the e:^ample 
given, the butter cost, estimated by the first method, 
was $0.74 but estimated by the second method it 
was $0.7375; the difference $0.0025 represents the 
hypothetical profit on the buttermilk. Thus, the 
crediting of the sale of the by-product in joint- 
product accounting introduces market values and 
profits into cost in a way that might be considered 
far more objectionable than the methods suggested 
for treating co-products. However, it is the only 
feasible way of treating joint-products, and is 
neither illogical nor entirely inaccurate. 

The accountant may insist that crediting the sale 
of the by-product is based on the principle that what- 
ever is made on buttermilk is so much gained and 
that the disposal of buttermilk tends to reduce the 



104 ECONOMICS FOR THE ACCOUNTANT 

cost of butter. However, it should be apparent that 
the selling price of buttermilk has nothing to do 
with the cost of butter, and that the deduction is 
justified only on the assumption that the butter- 
milk price will correspond roughly to the butter- 
milk cost and that its subtraction from the total cost 
will leave the actual butter cost. 



CHAPTER X 

THE DOUBTFUL ELEMENTS OF ACCOUNTING COST 

It has been explained that practically all account- 
ants agree that certain elements enter into account- 
ing Cost of Sales as for example, Eaw Materials, 
Depletion, Wages, Rent actually paid, the miscel- 
laneous items of Factory Overhead, * Depreciation, 
General and Administrative Expense, and Selling 
Expense. The Income and Excess Profits Taxes are 
usually excluded, although for some purposes, they 
may be included in cost. Interest is usually excluded, 
although interest actually paid or interest on short- 
term loans, lasting for less than the production 
period under consideration, are often considered cost 
items. In this chapter, the following items will be 
discussed: Interest, Rent, the entrepreneur's salary, 
and Depreciation. The treatment of Outward 
Freight, of Discount on Sales, and of Bad Debts will 
be postponed for Appendix II. The complete dis- 
cussion of Interest as a cost item will be given in 
Appendix I; only the outline of the theoretical 
aspects of the problem will be presented in this chap- 
ter. The discussion of taxes in cost will be post- 
poned for attention in Chapter XIV and Appendix 
II. This chapter will be limited to a discussion of 
the doubtful cost items, which are of general eco- 
nomic interest. 

105 



106 ECONOMICS FOR THE ACCOUNTANT 

Interest in Cost. — The accountant's most logical 
defense for the exclusion of Interest, whether on 
bond 3 notes, or on the entrepreneur's own capital, 
and Eent, unless actually paid to some other person 
than the producer, might be based on the fact that 
he is not keeping a cost for an entrepreneur but for 
a person or group of persons, who are not only entre- 
preneur but also capitalist. The accountant might 
maintain that this producer, or entrepreneur — capi- 
talist, can only consider as his costs his actual dis- 
bursements to others Thus, such a producer could 
not include in cost an interest charge, payable to 
himself as capitalist. Furthermore, inasmuch as the 
accountant refuses to allow interest on bonds or on 
notes, actually paid to outside capitalists, it might 
seem that accounting cost represents the expen- 
ditures of the entrepreneur and capitalist combined, 
and that what the accountant ultimately obtains by 
subtracting cost from price is Gross Profit which rep- 
resents a combination of economic profit and econ- 
omic interest. The accountant would then seem to be 
making up his statements for the bondholders and 
noteholders, and for the banks, as well as for the stock- 
holders. The accountant would probably justify this 
combination of interest and profit by insisting that 
there is never a pure entrepreneur and that the 
entrepreneur and capitalist are always combined in 
the same person or persons. The fallacy in this con- 
tention and the misconceptions arising therefrom 
will be discussed in Chapter XII and in Appendix I. 

The accountant's best theoretical reason for not 
finding the pure entrepreneur's cost is that when the 



DOUBTFUL ELEMENTS OF ACCOUNTING COST 107 

entrepreneur is also capitalist, his cost would have 
to include interest on his capital. Thus, in with his 
expenditures there would seem to be included a pay- 
ment due the entrepreneur himself, although due him 
as capitalist and not as entrepreneur. Accountants 
have argued that nothing should be included in cost 
except what is actually paid to others tban the 
person or persons for whom the cost is being com- 
puted. If the producer, that is, the entrepreneur — 
capitalist, can only consider, as cost items, disburse- 
ments to others, a salary paid the entrepreneur, 
when he works, would not be a legitimate part of 
cost. Yet, every accountant allows such salaries in 
Administrative Expense. The inclusion of the entre- 
preneur 's salary and the exclusion of interest imply 
that accounting cost is the sum of disbursements 
of the entrepreneur-capitalist, plus a payment to 
himself as laborer if he works. The entrepreneur's 
wage represents his own sacrifice cost; yet it is 
thrown in with his actual disbursements to others. 
The inconsistency of excluding interest on the entre- 
preneur's investment, because he pays it to himself, 
and of including at the same time a salary, paid to 
himself, should be obvious. 

The inclusion of sacrifice cost along with money 
disbursements is not so illogical as it may seem. The 
laborer 's sacrifice cost is a consideration of no direct 
interest to the accountant, who is only interested in 
what the entrepreneur has to pay, that is, wages. 
Whether the laborer's productivity would warrant 
a higher wage is no concern of the accountant. The 
accountants, however, are always considering the 



108 ECONOMICS FOR THE ACCOUNTANT 

entrepreneur's sacrifice costs. Therefore, why 
should they not include in costs his sacrifices when 
he works or when he employs his own capital. A 
true entrepreneur's cost, then, should include his 
salary when he works and an interest charge when 
he employs his own capital. Whether the accountant 
should attempt to find the entrepreneur's cost or the 
entrepreneur-capitalist's cost is a problem to be 
further discussed in Chapter XII and Appendix I. 

Rent as a Cost Item. — Accountants allow Rent in 
cost if it is actually paid, but if the producer owns 
the land on which he operates, he is not allowed to 
include an estimated charge. It must be evident 
from what was said on page 23 in Chapter III that, 
from the producer's point of view, land is like any 
other capital goods, and that when the entrepreneur 
discontinues renting and purchases a piece of prop- 
erty, his cost is no longer a rental but the combina- 
tion of an interest charge on the capital which made 
the purchase possible together with taxes and insur- 
ance. There certainly can be no objection to the 
inclusion of Rent in cost, but it seems inconsistent 
to consider rent actually paid as a part of cost when 
interest actually paid is not included. The exclusion 
of Rent from cost, however, would limit the account- 
ing conception of cost still further and would make 
it the entrepreneur-capitalist-landowner's cost. A 
true entrepreneur's cost would include not only the 
rent actually paid but also an interest charge on the 
capital investment plus the insurance and taxes 
actually paid, rather than an estimated rent on the 
property owned. 



DOUBTFUL ELEMENTS OF ACCOUNTING COST 109 

One reason, sometimes nrged even by economists, 
for the exclusion from cost of interest and rent due 
tlie entrepreneur is based on a confusion of capital 
and capital goods. If a producer has such a high 
cost that he suffers a loss, it is customary to say that 
"he earns nothing on his capital" or that *'his capi- 
tal earns nothing." What is meant is that his capi- 
tal goods earn very little or nothing. Capital is 
only indirectly productive, that is, as it is trans- 
ferred into capital goods. As a matter of fact, his 
laborers may not have earned their wages, or prices 
may have been demoralized; his capital goods, how- 
ever, may have been very effective and their specific 
productivity may have more than covered the inter- 
est charge.^ Inasmuch as bills and laborers are paid 
first, it is often believed that what is left is earned 
by the capital or capital goods. This is obviously 
fallacious. What is earned by the capital goods 
need not coincide with the interest that is paid on 
capital. The laborer's productivity is not always 
exactly equal to the wages he receives. If a laborer 
does nothing but receive his wage, his wage is never- 
theless a cost. Thus, even though the capital goods 
earn nothing, interest is not necessarily obviated. 
If capital is badly invested so that the capital goods 
earn very little, the entrepreneur, nevertheless, must 
include interest in cost even if he shows a loss. 
Whenever laborers fail to earn their wages or the 
productivity of capital goods is less than the interest 
charge, the entreprene ur suffers. Thus, capital 

* See Chapter IV. 



110 ECONOMICS FOR THE ACCOUNTANT 

demands interest even tliongli the capital goods earn 
little or nothing. 

When laborers fail to earn their wages, the entre- 
preneur attempts to discharge them or reduce their 
pay. It must be conceded that the entrepreneur can- 
not immediately dispose of his capital goods if they 
are not efficient. When he has interest to pay on 
the capital he borrowed to procure them, this inter- 
est is obviously a part of his cost as long as he con- 
tinues to pay it. It makes no difference how value- 
less his plant or machinery may have become. If 
he owns the capital that is represented by the capital 
goods, the interest charge is due him as capitalist. 

Depreciation as a Cost Item. — Although practi- 
cally all of the representative accountants have come 
to consider Depreciation a cost item, some manufac- 
turers have not yet learned to include it. It was 
stated on page 85 that when the entrepreneur owns 
capital or has it transferred to him, he uses it for 
two purposes: (1) for fixed investment that is sup- 
posed to last for a number of production periods; 
(2) for use in what are called current costs, such 
as materials, wages, rent, interest, etc. Materials 
like machinery and plant are capital goods but there 
is one difference between them; materials are used in 
one production period, whereas machinery and plant 
are supposed to last for many periods. However, a 
part of the machinery and plant are wasted in each 
period; therefore, a depreciation charge for this 
wastage is included in each production period. 
Depreciation might be defined as the part of the 
fixed capital goods used up in production. The 



DOUBTFUL ELEMENTS OF ACCOUNTING COST 1 1 1 

depreciation and the fixed capital goods, of whicli it 
represents a part, can be analyzed, just as materials 
are, into wages, interest, rent, and profit.^ 

There is another question concerning the inclusion 
of Depreciation in accounting cost. Depreciation 
differs from the cost of Raw Materials in one impor- 
tant respect, namely, the cost of Raw Materials is 
actually paid to others whereas the entrepreneur, 
as owner of the capital goods, seems to be putting by 
Depreciation for himself. But Depreciation is, after 
all, not paid to him but to others, to those from whom 
he originally purchased his fixed capital goods. But 
they probably demanded payment in advance and he 
had to borrow or use his own capital to consummate 
the purchase. Therefore, Depreciation becomes an 
obligation that he must live up to in order to keep 
faith with the capitalist. In the final analysis, how- 
ever. Depreciation is the cost of that part of the 
permanent capital goods wasted iii a production 
period, and as a cost item should be classed with 
Raw Materials. 

Sometimes certain practical objections are urged 
against the inclusion of Interest in cost. Although 
they will be discussed in Appendix I, it seems neces- 
sary at this point to mention them. It is said that 

* Thus, Depreciation is an accounting, but not an economic, cost. 
Economic cost is measured by the sacrifices made in carrying on pro- 
duction. When capital goods are produced, the economic costs are 
the efforts of the laborers, the sacrifices of the capitalists and land- 
owners, and the skill and services of the entrepreneur. The deprecia- 
tion of the fixed capital goods represents the using up of a portion 
of these embodied economic costs, but to count depreciation as an 
economic cost would merely represent a duplication of these embodied 
economic costs. They were counted once when the capital goods were 
produced, and should not be recounted when the capital goods are 
used up. 



112 ECONOMICS FOR THE ACCOUNTANT 

it is hard to determine what interest rate should be 
allowed on the entrepreneur's own capital and that 
it is often difficult to determine what his capital is. 
The method of determining capital will be discussed 
in Chapter XI and the difficulties involved will be 
set forth. It will be shown in Appendix I that the 
determination of the rate of interest is not so difficult 
as it seems. But could it be any more difficult to 
determine a proper interest rate than to fix a proper 
rate of depreciation? Depreciation is usually found 
by estimating the probable life of the capital goods 
that are being depreciated and by charging them off 
each year at the same rate until the accumulated 
depreciation equals the original cost of the invest- 
ment. This method of determining depreciation is 
both fallacious and inaccurate. The actual amount 
wasted should be charged off, for instance, if a 
machine was half worn out after its first year, one- 
half should have been charged off even though by 
great care its lifetime was subsequently prolonged. 
Furthermore, when the entrepreneur works and pays 
himself a salary, he estimates his own worth. There 
is no more difficult estimate to make than this one, 
and it is probably one of the least dependable. When 
the entrepreneurs want to hide excessive profits, this 
category is the usual receptacle. 



CHAPTER XI 

CAPITAL, CAPITAL GOODS, AND INVESTMENT 

Uses of Capital. — Inasmucli as so many of the 
problems that have been presented depend upon the 
definition of capital and the distinction between 
capital, capital goods, and investment, it seems neces- 
sary to amplify what has already been said about 
these concepts in some of the earlier chapters. If 
Interest is to be included in cost, on what should 
this Interest be calculated? It was explained on 
page 25 in Chapter III that capital represents the 
postponed claims of potential consumers expressed 
in terms of money. After capital has been trans- 
ferred to an entrepreneur, it might be called produc- 
tive capital. It was stated that the entrepreneur 
uses this productive capital in order to obtain fixed 
capital goods and to pay current expenses; the capi- 
tal goods legally belong to him and not to the capital- 
ist. The entrepreneur, then, uses capital for three 
different purposes: first, for fixed investment, such 
as land, buildings, and machinery; second, for 
materials to be used up in one production period; 
and third, for paying wages, rent, and interest to 
those who are associated with him in production. 
Thus, all capital is not transferred into capital goods, 
such as fixed investment or materials; a part is used 
to pay wages, rent, interest. 

113 



114 ECONOMICS FOR THE ACCOUNTANT 

If consumers paid for goods before they were pro- 
duced, rather than afterwards, the entrepreneur 
would not need capital for capital goods except for 
the fixed investment. Entrepreneur's cost covers the 
entrepreneur's entire expenditures for materials 
used up in the production period together with his 
outlay for wages, rent, and interest, but it is only 
expected to cover the depreciation on the fixed 
investment and not the entire cost of such invest- 
ment. If the price the consumer pays covers these 
costs, and if prices were paid in advance, the entre- 
preneur would have all the capital necessary to pay 
these expenses, but he would not have enough to 
pay the entire cost of the fixed capital goods, as 
price is supposed to cover only the depreciation 
thereon. When the entrepreneur sells his goods he 
can often cancel his short time obligations ; hence he 
is not always obliged to pay interest on all of his 
borrowed capital for the entire production period. 

The Need for Determining Capital. — It is evident 
that the entrepreneur's cost includes not only the 
wages and rent paid and the capital goods used but 
also the interest on the capital out of which the 
entrepreneur makes his payments and with which 
he obtains his capital goods. The determination of 
the amount of the capital on which interest should 
be paid is a problem of great importance. It is often 
urged that the difficulty of the problem stands in 
the way of the inclusion of interest in cost. But this 
argument has no value when it is remembered that 
even if interest is not allowed in cost, the producer 



CAPITAL AND INVESTMENT 



115 



usually calculates his "investment." As a basis on 
wMch to measure liis return or for the determina- 
tion of the capital used for certain of the profit 
taxes, the calculation of investment is necessary. 
Some cost accountants refuse to consider the prob- 
lem of investment, and seem to think that the cost, 
with no allowance for interest, is all that concerns 
them. It should be obvious that the comparison of 
the costs of the various plants of a company would 
be meaningless if in some of those plants the land 
and buildings were owned and in others rented, 
because the accountant allows rent actually paid 
as a cost item but he would not allow interest on the 
capital invested in the owned plants. Even if inter- 
est were not allowed as a cost item, it would be 
necessary to have the investments in the various 
plants as well as the costs for a comparison of their 
efficiencies. Thus, if there were two plants operat- 
ing under identical conditions, except for the fact 
that the one was owned and the other rented, the 
following would be the costs thereof: 





Cost per unit 

for Rented 

Plant A 


Cost per unit 

for Owned 

Plant B 


Raw Material 


$1.00 
.60 
.20 
.40 


$1.00 


Wages 


.50 


Rent 


.00 


Overhead, etc 


.40 






Total Cost (excluding Interest but 
including Rent actually paid) . . . 


$2.10 


$1.90 



116 ECONOMICS FOR THE ACCOUNTANT 

Plant B would seem to be lower in cost than Plant 
A, but this would not really be true because Plant 
A might have an investment of $5.00 per unit of 
product and Plant B would probably have an invest- 
ment of $9.00 per unit. Plant B 's larger investment 
would be explained by the fact that the land and 
buildings were owned whereas in Plant A they were 
merely rented. Then, even if Interest were not 
included, the investments, per unit, should be shown 
as follows: 





Cost per unit 

and Investment 

per unit 

for Plant A 


Cost per unit 

and Investment 

per unit 

for Plant B 


Total Cost 


$2.10 
5.00 


$1.90 


Investment 


9.00 







Obviously this method of presentation would be 
less satisfactory than the following: 





A 


B 


Cost (minus Interest) 


$2.10 
.25 


$1.90 


Interest (at 5 per cent) 


.45 






Total Entrepreneur's Cost 


$2.35 


$2.35 



The Balance Sheet. — The Balance Sheet is used to 
determine the capital or ''investment" on which 
Interest or "return" is computed. The following 
Balance Sheet represents a condensation of the form 
shown in Chapter II: 



CAPITAL AND INVESTMENT 117 

Assets Liabilities 

1. Cash 8. Bills, Notes, and Accounts 

2. Notes and Accounts Receiv- Payable 

able 9. Other Current Liabilities 

3. Inventories 10. Bonds and Mortgages 

4. Other Quick Assets 11. Preferred Stock 

5. Outside Investments 12. Common Stock 

6. Fixed Assets 13. Surplus 

7. Deferred Charges 

Inasmucli as capital is the basis of interest, the 
liability side of the balance sheet is probably the 
better side to attack. However, the asset side, 
which includes the capital goods, should not be 
neglected. 

If a business were assumed to be starting its cor- 
porate life, the capital obtained through the sale of 
Bonds (10) and Stocks (11 and 12) would probably 
be transferred into the Fixed Assets (6). Some of 
the capital obtained in this way might be used for 
buying materials or paying current expenses; in that 
event, a part of the permanent capital (10, 11, and 
12) would be represented here by Inventories and 
Cash (1 and 3). However, it might be better to 
finance the materials and expenses represented by 
the fluid assets (1 and 3) through short-term notes, 
which could be renewed if necessary. Many firms 
renew short-term notes so often that they practically 
become permanent capital. It may be noticed that 
the Surplus (13) has not been considered. The Sur- 
plus belongs to the common stockholders. When a 
business begins its corporate life, there is probably 
no Surplus. However, if some of the common stock- 
holders had paid more than par for their stock, 



118 ECONOMICS FOR THE ACCOUNTANT 

there would be a Surplus because the Common Stock 
would be shown at its par value/ 

The Balance Sheet is a picture of the business at 
any one time. In order to get a true picture of a 
business for a year a Balance Sheet would be needed 
after every transaction. As production goes on, 
there is a constant flux on the asset side: Raw 
Materials are taken out of the Inventories, expenses 
are paid out of Cash, the Fixed Assets are depre- 
ciated; then, as the finished products are sold, the 
Cash or Bills Receivable are increased. While these 
changes in the various items are taking place, the 
total value of the assets may not seem to change. 
However, if the finished products are sold for more 
than cost, the total assets are increased. In that 
event, there must be a corresponding increase on the 
liability side, which is registered in Surplus. There 
is another way in which the value of the total assets 
may seem to be increased without the bringing in 
of new capital or without the realization of profit on 
sales. If the capital goods, that is, the assets, 
acquire an increased market valuation, the capital 
may seem to increase. The entrepreneur, the stock- 
holders, would seem to have acquired an increment 
of value; if this increment of value were allowed in 
an increased valuation of the assets, it would prob- 
ably be offset by an increase in the Surplus.^ 



* Thus, if a company had sold 100,000 shares of common stock for 
$110 per share, the common stockholders would have supplied the 
business with $il,000,000 capital. If the par value of the stock were 
$100 per share, the Common Stock on the Balance Sheet would be 
$10,000,000 and the Surplus $1,000,000, 

* Unless new common stock were issued. 



CAPITAL AND INVESTMENT 119 

The Valuation of Capital Goods. — ^At this point it 
is necessary to consider the different reasons which 
might explain an increased valuation of the capital 
goods. 

First, capital goods may seem to increase in 
value because of some peculiar outside demand. If 
a manufacturer had been offered twice his purchase 
price for a piece of the land adjacent to his factory, 
he might have been tempted to revalue this piece of 
land. However, if he did not actually sell it, he had 
no right to revalue it on the basis of an opportunity 
price. Although its specific productivity in his busi- 
ness might not have warranted such a revaluation, 
he might not have been able to part with it without 
impairing his business. As an entrepreneur, he had 
a legal claim to the piece of land but his claim to its 
apparently increased value was unjustified until he 
actually sold it. It appears, therefore, that the 
entrepreneur's claim on a hypothetical increment of 
the increased value of the capital goods is of a some- 
what different nature from the capitalist's capital, 
which is originally a claim on consumption goods. 
The entrepreneur cannot claim consumption goods 
until he has actually sold the capital goods, and he 
cannot claim them legally until he has satisfied the 
capitalist. 

Second, the value of the capital goods may seem 
to exceed the value of the capital because of their 
productivity. This may come about in one or two 
ways : first, the entrepreneur may transfer the capital 
into capital goods of a productivity far greater than 
the interest he has to pay; second, he may improve 



120 ECONOMICS FOR THE ACCOUNTANT 

the capital goods, originally purchased, so that their 
productivity is thereby increased. In both cases 
the seeming productivity of the capital goods is 
actually their productivity plus the productivity of 
the entrepreneur. However, the entrepreneur can- 
not claim that their value as capital goods has 
increased until he sells them. Their greater produc- 
tivity results in a greater profit for him; thus, their 
apparently increased value results in larger profits 
rather than in a larger capital valuation and more 
interest. 

Third, capital goods may acquire a greater mone- 
tary valuation in a period of increasing prices. A 
piece of land purchased for $1,000 in 1900 might 
have produced 10,000 units of product worth in that 
year $100. To-day, the same land might have a 
generally recognized valuation of $2,000, but the 
10,000 units of product would probably bring $200. 
The farmer who bought his land 30 years ago would 
to-day get twice as much from it as in 1890. It 
might seem that the land should be revalued at 
$2,000. However, the increased productivity, in 
money terms in this case, is all that the entrepreneur 
can consider until he sells the land and receives the 
$2,000 for it, and the increased productivity is profit, 
not interest. When a business sells a 5 per cent 
bond for $1,000, the bondholder, the capitalist, con- 
tinues to receive $50 a year even in a period of rising 
prices when the capital goods may be earning $100 
a year. The difference, the other $50, is profit, not 
interest. This principle may seem to put the older 
business, which purchased its capital goods with a 



CAPITAL AND INVESTMENT 121 

smaller amount of capital, at a disadvantage when 
compared with the new business. However, it 
depends upon the purpose for which the capital is 
being determined whether the principle is of advan- 
tage or disadvantage to the business. For the pur- 
pose of the Income Tax, a large capital seems desir- 
able; but if the business would show its true profit, 
it should not revalue its assets. 

In short, when capital is invested in capital goods, 
they cannot be considered as having a capital value 
different from that of the capital, which made them 
possible, until they are sold and are no longer capi- 
tal goods. If they remain capital goods, they have 
no value except that derived from their productivity, 
and they can have no independent valuation except 
their original cost, which represents the invested 
capital. 

The valuation of the Balance Sheet items at orig- 
inal cost will give the original amount of capital in- 
vested, and this capital is the only proper basis for 
the calculation of interest. When capital goods take 
on an apparent social valuation in excess of the value 
of the capital, the entrepreneur seems automatically 
to become a capitalist and to have a claim on the 
increased valuation ; but he has no real claim to any 
surplus value in the capital goods until he sells them, 
when he is no longer entrepreneur but capitalist. 
If it would he remembered that it is capital and not 
a vahmtion of the capital goods that is the basis of 
interest, no di-fficidty tvould arise. The original 
cost of the capital goods, which might have been less 
or more than their value at the time of their pur- 



122 ECONOMICS FOR THE ACCOUNTANT 

chase, corresponds to the amount of the capital in- 
vested in the business. 

Although no increase in the value of the capital 
goods may be allowed on the Balance Sheet, it should 
be noted that even if the stockholders own little or 
no capital at the beginning of an enterprise, they 
become capitalists as profit is realized. The entre- 
preneur who keeps his profit in the business has as 
much right to consider that he has foregone con- 
sumption as the capitalist. Thus, the entrepreneur, 
even if he did not supply any capital at the inception 
of the business, becomes a capitalist if he does not 
withdraw his profit. Profits and interest left in 
the business represent the stockholders' postponed 
claims to consumption goods and are, therefore, 
capital. 

Thus far, the Balance Sheet has been considered 
only for the purpose of determining the investment 
or capital on which interest can be calculated. It 
might seem that if the entrepreneur were showing 
his Balance Sheet to the bankers or if he were con- 
templating selling the business, he would want to 
capitalize the earning power. If the capital of $1,- 
000,000 had been invested 20 years ago and if the 
capital goods to-day have a market valuation of 
$2,000,000, which could also be justified by a Gross 
Profit, interest plus profit, of $200,000, the entrepre- 
neur might be loath to have his Assets valued at the 
original cost of $1,000,000. However, no business 
should be judged merely from the Balance Sheet; 
the Profit and Loss accounts for a, series of years 
should supplement the statement of Assets and Lia- 



CAPITAL AND INVESTMENT 123 

bilities. Obviously, the Profit and Loss account 
would show the skill or luck of the entrepreneur, 
whereas the Balance Sheet should merely show the 
actual cost of the capital goods. A capitalization of 
earning power would be attributing to the capital 
goods a productivity that might rightfully be the 
result of what the entrepreneur actually accom- 
plished or, at least, obtained. 

The reasons usually given for revaluing capital 
goods for Balance Sheet purposes might be sum- 
marized as follows : 

1. A particular piece of property or building may 
take on an increased valuation because of some out- 
side demand. However, as far as the business, for 
which the Balance Sheet is made, is concerned, this 
portion of the capital goods is no more valuable after 
the outside demand than before. If the high price 
offered does not cause the sale of the property, as it 
may be indispensable for the conduct of the business, 
the outside demand would probably be met from 
some other source, and a few months later the par- 
ticular piece of property under consideration might 
have no such opportunity value. However, if a piece 
of property continues to have a high opportunity 
value, but cannot be sold by the business for which 
the Balance Sheet is being made, this fact can be set 
forth for the benefit of the banks from which the 
business may want to borrow. However, the reval- 
uation cannot be justified from the point of view of 
the business unit, that owns it. 

2. A part or all of the capital goods may Become 
more valuable because their productivities may have 



124 ECONOMICS FOR THE ACCOUNTANT 

increased due either to (a) tlie entrepreneur's, or 
his salaried agents', clever use of the capital goods, 
or to (b) the general rise in prices, which is reflected 
in higher prices for capital goods and for the prod- 
uct as well as in greater profits. In both examples, 
{a and b), the greater productivity is reflected in a 
greater return on investment, to use the account- 
ant's terminology. This return is a combination of 
interest and profit. It is obvious that the increased 
return is due to larger profit because the interest is 
stationary and represents a certain fixed portion of 
the original capital. A revaluation of the capital 
goods on the Balance Sheet would seem to increase 
the interest charge and to reduce the profit. Thus, 
such a revaluation could be used to hide excessive 
profits, but it would be fallacious because it would 
falsify the basis of the interest charge. If business 
firms were to revalue consistently on the basis of 
productivity, every firm could fix up a Balance Sheet 
so as to show the same percentage of return, interest 
and profit, as every other firm. 

Goodwill. — The problem is somewhat complicated 
when a corporation is to be sold to another cor- 
poration. In the next chapter a type of incorporation 
will be referred to, the modus operandi of which 
should be described here. If the stockholders of a 
company had invested $15,000,000 in original capi- 
tal and reinvested profits the Balance Sheet might 

be as follows : 

Assets 

Buildings, Machinery, Inventories, Cash, etc $15,000,000 

Liabilities 
Common Stock and Surplus $15,000,000 



CAPITAL AND INVESTMENT 125 

This business might have been earning about $5,- 
000,000 in interest and profit a year, or 333^ per 
cent on the invested capital. The stockholders would 
hardly have been satisfied to take $15,000,000 in cash 
for this business, which represented a $15,000,000 
investment and which was earning 33>^ per cent 
thereof. In many instances the stockholders sell 
their business to a newly created corporation, for an 
issue of $15,000,000 worth of seven per cent preferred 
stock and $40,000,000 worth of common stock. Then 
the new corporation's Balance Sheet might be as 
follows : 

Assets 

Buildings, Machinery, Inventories Cash, etc $15,000,000 

Goodwill 40,000,000 

Liabilities 

Seven per cent Preferred Stock $15,000,000 

Common Stock 40,000,000 

The ''Goodwill" would be considered justified by 
the productivity or earning power of the corpora- 
tion. After the seven per cent dividends on the pre- 
ferred were paid, there would stiU be $3,950,000 or 
$5,000,000 minus $1,050,000, left for the common 
stock, that is 9.8 per cent. The original stockholders 
of the first corporation, then, would sell the pre- 
ferred stock but they would probably hold the com- 
mon stock. Those who bought the preferred stock 
in the market would be supplying the capital, or 
rather they would be allowing the original stock- 
holders to withdraw their $15,000,000 investment. 
The preferred stockholders would then represent the 
outside capitalists and the original common stock- 
holders, who had been entrepreneur-capitalists, 



126 ECONOMICS FOR THE ACCOUNTANT 

would now be pure entrepreneur, as owners of the 
$40,000,000 common stock, which represented no 
investment. 

The capital invested in the second corporation 
would be $15,000,000, no different from that invested 
in the first; yet, the assets of the second company 
would show $40,000,000 Goodwill, in addition to the 
$15,000,000 original cost of the capital goods. If 
Goodwill is shown clearly on the Balance Sheet, 
there is no harm done. However, the accountant 
should realize that when he is computing the capital 
invested, he should add the common and preferred 
stocks to the bonds and other interest-bearing lia- 
bilities hut he should deduct the Goodwill on the 
asset side. It is far easier to deal with this kind of 
reappraisal than with the revaluations of specific 
capital goods, which are not so easily detected. 

When a corporation spends money perfecting a 
patent or in developing a trade-name through adver- 
tising or otherwise, this investment is often used to 
justify the * ' Goodwill ' ' on the Balance Sheet. Thus, 
the expenditure of a few thousand dollars is often 
considered justification for a Goodwill item of mil- 
lions. The Balance Sheet should show the actual 
amount of capital so expended, as it is a legitimate 
addition to investment, but the amount of Goodwill 
added as a result of the earning power should be 
shown separately so that it will not be included in 
the invested capital. 

If the holders of the $40,000,000 of common stock 
afterwards sold a quarter of their holdings to out- 
side capitalists, and the $10,000,000 of capital sur- 



CAPITAL AND INVESTMENT 127 

rendered were invested in the corporation, some of 
the Goodwill might be squeezed out, provided the 
controlling stockholders did not demand notes for 
the $10,000,000 of their capital.^ Then the Balance 
Sheet would be as follows : 

Assets Liabilities 

Old Assets $15,000,000 Preferred Stock $15,000,000 

New Assets 10,000,000 Common Stock 40,000,000 

Goodwill 30,000,000 

Short-Term Notes.— If $1,000,000 of capital had 
been secured by the sale of bonds and stocks, and if 
$100,000 had been borrowed from the banks at five 
per cent for the three months March to May, the 
actual interest paid on the note is considered by some 
accountants to be a part of cost. Then, if cost were 
$4,000,000, excluding all interest, the total cost would 
be $4,005,000 and the investment $1,000,000. The 
second possible way of treating these figures would 
be to consider the cost $4,000,000 and the investment 
$1,025,000, as already explained in the foregoing 
paragraphs. The inclusion of interest in cost would 
obviate the difiiculties of both methods. If there had 
been a $400,000 six per cent bond issue, and if the 
stock had been sold when the interest rate for long- 
term investments of the same amount of risk was five 
per cent, a total interest charge of $59,000 ($5,000 
on the three-months' note, $24,000 on the bonds, and 
$30,000 on the stockholders' investments) could have 
been added to the cost, $4,000,000, and the problem of 
investment would have been obviated. 

The accountant uses the term ** investment" in- 

* This would be unusual but not improbable. 



128 ECONOMICS FOR THE ACCOUNTANT 

stead of ''capital." He says, for example, *'a pro- 
ducer should have a return on liis investment " or " in- 
terest on investment should not be included in cost." 
He sometimes means by "investment" that part of 
the capital used through the entire year, that is, the 
capital represented by the fixed capital goods, such 
as lands, buildings, and permanent machines. That 
part of capital that goes into materials, wages, rent, 
and interest may be neglected by him if these ex- 
penses are financed through short-term notes, that is, 
notes running for less than a year. Some accountants 
include interest on short-term notes in cost and 
thereby dispose of them. Those who believe in the 
pure entrepreneur's cost and who consider interest a 
cost item will feel that this is a step in the right 
direction but they will have to admit that it is not 
consistent with the exclusion of other interest from 
cost. If the accountant insists upon a consistent en- 
trepreneur-capitalist's cost, short-term notes would 
have to be included in the capital or investment 
along with the bonds. However, inasmuch as they 
would not run through the entire production period, 
an adjustment would have to be made. Thus, if a 
company borrowed $40,000 at six per cent for three 
months, the loan might be considered identical with 
a year's note for $10,000 at about the same rate of 
interest. 

The Basis of the Interest Charge. — If Interest is to 
be treated as a cost item, it should be apparent that 
from no one Balance Sheet can the capital used 
during a production period be determined. The short 
term notes may have been borrowed in March and 



CAPITAL AND INVESTMENT 129 

paid off by November ; thus, no evidence of their ex- 
istence could be found on the Balance Sheets at the 
beginning or at the end of the year. There is another 
reason why neither the first nor the last of the 
Balance Sheets mil give the capital invested 
accurately. The first and last Balance Sheets differ 
ordinarily only by the amount of profit earned on the 
sale of goods.* If the business is a corporation, this 
profit is really the interest and profit of the stock- 
holders. The profit is usually earned in varying 
amounts all through the year. Thus, some parts of 
the total profit of a year would be in the business 
for almost 12 months, whereas some parts would be 
earned in December and would be capital for less 
than a month. Unless some special condition existed 
one-half of the total profit could be considered the 
average reinvested profit to be added to the capital. 
In order to determine the interest that should be 
added to cost, the Balance Sheets at the beginning 
and at the end of the year, together with a record of 
interest actually paid on short-term notes running 
for less than a year would be necessary. The interest 
on short-term notes and on bonds and the so-called 
dividends on the preferred stocks could be added to 
cost, and no estimates would be necessary. Then," 
assuming that the capital goods, the assets, were 
Valued at original cost, the stockholders* capital 
could be determined from the first Balance Sheet, 
and the profit earned and interest accrued for the 
stockholders could be determined from the last. 

* New capital or the sale of the capital goods, assets, might explain 
a larger capital on the last Balance Sheet than on the first. 



130 ECONOMICS FOR THE ACCOUNTANT 

It should be apparent that the interest rate to be 
charged on the stockholders' capital should be the 
interest rate prevailing for that kind of investment 
at the time the capital was invested, and that the 
rate to be charged on the profit and interest earned 
during the year should be at the rates prevailing at 
the time the profits and the interest were realized. 
Obviously, when a bondholder invests his money in 
five per cent bonds, he must always expect a five per 
cent return, no matter how the interest rate may 
change subsequently. "When the stockholder invests 
his capital, he should have thereafter the interest 
rate for long-term investments prevailing at the time 
he invested. 

The Bills Payable, which bear no interest, should 
be separated from the Notes Payable and should not 
be considered a part of the corporation's capital. 
These bills represent the capital of other entrepre- 
neurs, but the entrepreneur for whom the capital is 
being determined does not have to pay interest on 
them, and, therefore, should not include them in his 
capital. 

A summary of the steps to be taken in order to 
determine the interest charge and the basis on which 
estimated interest should be charged may be given 
as follows : 

The dividends on the preferred stock, assuming 
that the preferred stock is of the kind already 
described, should be added to the interest on the 
bonds and short-term notes, that is, on all interest- 
bearing paper, and this total of interest paid or 
payable should be added to cost. 



CAPITAL AND INVESTMENT 131 

The Balance Sheet as of January 1 and of De- 
cember 31 should be obtained with all the assets 
valued at original cost plus the improvements 
represented by actual capital investment. 

Then, from the Common Stock and Surplus, the 
Goodwill on the asset side should be deducted, if any 
Goodwill not represented by actual investment is 
included. 

The remainder will represent the common stock- 
holder's capital on which interest will have to be 
estimated. If the common stock was all sold when 
the company was incorporated, the accurate amount 
of capital represented by the original investment 
will be available. Then, this amount should be 
multiplied by the interest rate prevailing for invest- 
ments of this kind at the time of incorporation of 
the company. 

The profits and interest earned in former years, 
that were left in the business, will be shown in the 
Surplus of the first Balance Sheet. If the rate of 
interest changed materially during the years be- 
tween incorporation and the date of the first Balance 
Sheet for the year under consideration, some allow- 
ance will have to be made for the rate to be charged 
on the accumulated undivided profits, that is, the 
Surplus. 

The profits, or dividends, earned during the year 
under consideration will have to be considered as 
well as those earned in former years. It has been 
suggested that the year's profit, which usually is the 
difference between the Surplus of January 1, and 
that of December 31, should be cut in half and 



132 ECONOMICS FOR THE ACCOUNTANT 

multiplied by the rate prevailing during the year 
unless monthly Profit and Loss accounts can be used 
to determine this figure more accurately. 

There is one item on the asset side the valuation 
of which is much disputed. It has been explained 
that all the capital goods used in the business should 
be valued at cost, since this valuation represents 
the capital invested. The inventories of manu- 
factured goods, which are capital goods on the asset 
side, should accordingly be valued at their cost of 
production and all the inventories of raw materials 
should be valued at the prices paid for them. 
Although accountants attempt to value inventories 
at cost both on the Profit and Loss account and on 
the Balance Sheet, they usually value them at the 
market price if market price is below cost. This 
procedure is followed because of its safety; the 
accountant believes that although it may have cost 
$1.00 to produce a certain commodity, if its market 
value is $0.80 it would be dangerous to allow the 
stockholders to think that they have an asset worth 
25 per cent more than its market value. The reader 
who has given consideration to this chapter should 
realize that the stockholder should never believe that 
the Balance Sheet tells the worth of his business at 
any time. If Inventories are to be revalued, why not 
the fixed assets? If the fixed assets cost $1,000,000, 
they are so valued on the Balance Sheet, even though 
their true market value at the time of their purchase 
or subsequently might have been as small as $400,000. 
Obviously, if the Balance Sheet is to be used to show 
the invested capital, Inventories must be valued at 



CAPITAL AND INVESTMENT 133 

cost whatever their market value may be at the time 
the Balance Sheet is drawn. 

But the accountant may object that this is not the 
only or even the principal purpose of the Balance 
Sheet. The Balance Sheet is supposed to show the 
value of the business on a certain date. If the banker 
picks up the Balance Sheet, he will be misled if In- 
ventories are valued at cost when their market value 
is below cost. The accountant may insist that the 
banker is not so much interested in the fixed assets 
as in the current ones, he wants to be shown a con- 
servative value of the Inventories, Eeceivables, and 
Cash so that he may have some idea of how readily 
the corporation could pay off his loans if the neces- 
sity should arise. Obviously, it would be bad account- 
ing principle to value the Fixed Assets on one basis 
and the Current Assets on another. Furthermore, a 
Balance Sheet would have to be made for a par- 
ticular moment and might be useless soon thereafter. 
For the banker's enlightenment a note could be 
appended to the Balance Sheet with regard to the 
value of the Current Assets, particularly the Inven- 
tories, but on the Balance Sheet original cost should 
prevail. 

The valuation of the Inventories on the Profit and 
Loss account in determining the Cost of Sales is 
also disputed by accountants. It is sometimes argued 
that ** safety first" would involve cost or market 
value, whichever happened to be lower. As a matter 
of fact, the following simple example will show that 
at times it might be more conservative to use cost 
even when higher than market value : 



134 ECONOMICS FOR THE ACCOUNTANT 







Inventories 
at Cost 


Inventories 
at Market 


Sales 

Cost of Production 


$1.00 
.50 


$1200 
1000 

+ 10 


$1200 
1000 


1st Inventory (10 units) : 

Cost 

Market Value 


+5 






Total 


$1010 
-10 


$1005 


2nd Inventory (5 units) : 

Cost 

Market Value 


$2.00 
1.50 


-7.50 






Cost of Sales 


$1000 
$200 


$997.50 


Profit 


$202.50 









Thus, the valuation at cost showed a smaller profit 
and is, for that reason, more conservative in this 
example than the lower market valuation would have 
been. However, the valuation at cost should not be 
justified by any such reasoning. The reason why 
Inventories should be valued at cost rather than sell- 
ing price on the Profit and Loss account is connected 
with the fact that the accountant is forced to con- 
sider an arbitrary fiscal period such as a year. An ex- 
ample will serve to illustrate the point. If 10,000 
units of a commodity were produced in November 
and December of 1916 at a cost of $0.10 per unit and 
if 100,000 units were produced during the year 1917 
at $0.20 per unit, the total cost for the period 
from November 1, 1916, to January 1, 1918, would be 
10,000 X $0.10+100,000 X $0.20, or $21,000. If the 
10,000 units produced in 1916 had not been sold by 



CAPITAL AND INVESTMENT 135 

the end of that year, they would have represented 
an Inventory. Now, if this Inventory had been sold 
in 1917, the profit realized would have been the dif- 
ference between the cost of $0.10 and the selling 
price, which might have been $0.20. Thus, when the 
accountant adds the money Inventory to the year's 
cost, he is really adding costs of two periods, 
the period November-December, 1916, and the period 
January to December, 1917. The same reasoning 
applies to the closing Inventory. If there are certain 
units left over after the end of the year 1917, the cost 
of those units should be deducted from the total costs 
expended, that is, the costs of the period November 1, 
1916, to January 1, 1918, in order to leave the costs of 
the units disposed of by the end of 1917. 



CHAPTER XII 

PRICE, PROFIT, AND COST 

Profit and the Entreprenexir. — In all that has gone 
before, the entrepreneur's costs have been discussed 
but the treatment of his share, profit, has been post- 
poned for this chapter. After the. accountant has 
determined the- cost of producing a certain article, he 
needs only to subtract this cost from the selling price 
in order to determine the entrepreneur's profit, 
assuming that the accounting cost is the entrepren- 
eur's cost and includes interest. When the account- 
ant has defined cost properly, his task seems ended. 
However, if past costs and estimated future costs are 
being used to determine selling prices, the account- 
ant may be called upon to fix what he considers a 
proper margin of profit to be added to cost. It is evi- 
dent that although the accountant may decide on 
what should go into cost, he cannot determine in a 
competitive system what price or profit, the differ- 
ence between price and cost, is actually going to be. 
If price is fixed by competition, no one producer can 
sit at his desk and fix his price or profit independ- 
ently. But it is probably more dangerous for the ac- 
countant to misunderstand the nature of profit than 
any of the other economic categories. 

It was stated on page 45 in Chapter IV that profit 
is the share of the entrepreneur, but just who the 

136 



PRICE, PROFIT AND COST 137 

entrepreneur is and just what lie does has not yet 
been completely discussed. In a private business this 
function is vested in the ultimate ''boss," and in a 
corporation in the stockholders. In Chapter III it 
was explained that the entrepreneur controls the 
business unit; actually only one part of the entre- 
preneur, the controlling stockholders or directors, 
has any voice in shaping its policies. It is often 
thought that the entrepreneur must render actual 
personal service either in organizing or directing, 
and that he is really a high type of laborer. As a 
matter of fact, his service is never active; if he 
works, he receives a salary and is a laborer. 

The Pure Entrepreneur. — ^Inasmuch as most of the 
entrepreneurs are also capitalists (the partners in 
an unincorporated business and the stockholders in 
a corporation, who furnish it with capital when they 
buy its stock) it is often assumed that the function 
cannot be vested in a man or group of men unless he 
or they be also capitalists. It seems worthy of con- 
sideration that during the last decade a type of im- 
portant industrial corporation has sprung up in 
which the capitalist and entrepreneur functions are 
often separated, at least temporarily.^ Some of the 
most important of our private businesses are being 
refinanced in a way that has already been described 
on page 124 in the preceding chapter. The original 
owner sells his business to a newly created corpora- 
tion and receives for it an issue of preferred stock, 
equal in value to the capital in the business, and an 

*See Kemper Simpson, "The Capitalization of Industrial Good 
Will, ' ' John Hopkins Press. 



138 ECONOMICS FOR THE ACCOUNTANT 

issue of common stock, behind which is *' Goodwill" 
or ''water." The preferred stock, then, is sold in the 
stock market by the original owners, who are usually 
expected or even required to hold the common stock. 
The preferred stockholders, thus, replace the capital 
withdrawn by the original entrepreneur-capitalist; 
they become the capitalists but he remains the entre- 
preneur because he holds the common stock. He has 
sold his capital and is a pure entrepreneur until he 
puts back some of his profits in the business. 

It might be maintained that the capitalists allow 
him to be the entrepreneur because of his ability as a 
laborer and that he is really a laborer-entrepreneur. 
Some of these common stockholders withdraw from 
active participation in the business and merely 
control its policy. Yet, they always own its product 
and its capital goods. The capitalist, it must be 
conceded, commonly expects the entrepreneur either 
to invest some of his own capital or to apply a high 
degree of executive ability and to render personal 
service. The capitalist wants assurance that the 
entrepreneur will be able to meet his obligations in 
the event of dissolution, should the capital goods de- 
preciate in value. Although at the inception of these 
reincorporations the entrepreneur and capitalist 
functions were embodied in different persons or 
groups of persons in the new industrial companies 
just described, as soon as profits were earned and 
were not withdrawn, the capital was increased and 
the entrepreneur automatically became a capitalist. 
However, although the entrepreneurial function and 
the capitalist function are commonly embodied in one 



PRICE, PROFIT, AND COST 139 

man, these functions are separate and distinct and 
should not be confused with each other. 

Functions of the Entrepreneur. — The pure entre- 
preneur is neither laborer nor capitalist; he merely 
owns the capital goods and the product and, through 
his ownership, holds control. In what active ways 
does he exert his control? First, if he is the original 
stockholder, he may organize the business unit. If 
he does n6t do this directly, he hires the laborers 
who do. Thus, the first stockholders are directly 
responsible for the formation and location of the 
particular aggregation of land, labor, and capital 
goods that make up the business unit. If they do no 
actual work, they, at least, had the original idea of 
the business. Second, they make decisions as to the 
general policy of the company whenever they vote. 
If they merely sign proxies, they surrender their 
rights to the directors. 

The ownership of the capital goods and of the 
product are always the function of the entrepreneur, 
but the organization and control function are usually 
vested in one part of the entrepreneur only. Al- 
though all of the common stockholders regularly 
have a right to vote, the control is probably held by a 
few of the directors, who are elected by the majority 
stockholders. Thus, many of the common stock- 
holders of modern corporations merely supply 
capital on easy terms, that is, they do not have to be 
assured an interest return, because they are prom- 
ised an equal share of the profits if any are earned. 
Theoretically, however, they are a part of the entre- 
preneur because they own the capital goods and the 



140 ECONOMICS FOR THE ACCOUNTANT 

product and they have the legal right to vote, even 
though customarily they are satisfied to sign proxies. 
The Risk Theory of Profit. — Inasmuch as the 
share of the entrepreneur is profit and as so many 
stockholders are merely part owners of the product 
and the capital goods, it has come to be believed by- 
many economists that this ownership and the risk 
inherent in it justifies or, at least, explains profit. 
The risk theory of profit is so widely held that it 
deserves some attention. The following paragraph 
is taken from an article published by me in the 
Quarterly Journal of Economics for November, 
1919: 

There seems to be no risk in ownership, per se, that would 
warrant compensation. The risk in the ownership of the 
product can be analyzed into two parts : the risk inherent 
in the possibility of not getting profit, and the risk of 
losing the capital or a part of the capital invested in the 
product. "With respect to the first kind of risk, no factor 
in production is absolutely assured of a share in distribu- 
tion. This is true of the laborer, although it is more 
conspicuous in the case of the capitalist and landowner. 
If an entrepreneur were to be compensated according to 
the risk he ran of getting profit, the most inefficient entre- 
preneurs could expect the highest rate of profit. With 
regard to the second kind of risk, Hawley acknowledges 
that this is a capitalist's risk and not an entrepreneur's 
risk. If the entrepreneur uses his own capital, he takes 
a risk as capitalist and not as entrepreneur. If he borrows 
his capital, the lender takes the risk. The risk inherent in 
the ownership of the product offers no sufficient justifica- 
tion for profit nor does it explain the variations in profit. 
The justification for the varying yields on capital due to 
different degrees of risk has been generally recognized. 



PRICE, PROFIT, AND COST 141 

The capitalist does not tale the risk of not getting interest 
but he stands the chance of losing his capital, i.e., the 
source of his income. "When a laborer is paid a high wage 
in a dangerous occupation, he is compensated for the risk 
of losing his wage. 

The risks of the factors of production may be 
summarized as follows : 

1. (a) Laborer takes little risk of losing wage 

because he is paid first, (fc) He takes little 
risk of losing source of Ms wage, that is, 
limb or life, except in dangerous occupation, 
where he demands a higher wage, as risk 
premium. 

2. (a) Landowner and owner of capital goods, 

such as buildings, etc., takes slightly- 
greater risk of not getting his share than 
laborer does of not getting his. Tenants 
do not always pay rent. (&) He takes little 
risk of losing the source of his rent, Ms 
land, but he may lose Ms capital goods ; so 
he insures them, and charges the insurance 
in Ms rent. 

3. (a) The capitalist takes a risk equal to that of 

landowner, or greater, of not getting in- 
terest. (&) He takes a considerable chance 
of losing Ms principal, as capital is often 
■ very soon dissipated. 

4. {a) The entrepreneur takes the greatest chance 

of losing Ms profit because he is paid last. 
(&) He takes no risk of losing the source of 
Ms profit in the way the capitalist risks los- 
ing his principal. 



142 ECONOMICS FOR THE ACCOUNTANT 

If risk explained different profits in the way that 
it explains different rates of interest, the marginal 
entrepreneur, who takes the greatest risk of failure, 
would theoretically get the greatest profit, a reductio 
ad ahsurdum. There is one sense in which profits 
might be affected by risk; in precarious industries, 
capital ventures cautiously and there would theoret- 
ically be few entrepreneurs, little competition, and 
great profits. This, however, is not the relation 
between profit and risk that some economists have 
claimed exists. And certainly this relation would 
offer no good ground for justifying profit as a return 
for the risk the entrepreneur runs. The risk of the 
entrepreneur is not to be compared with the capital- 
ist's risk, and differences in interest rates are 
explained by differences in risk, whereas differences 
in profits are not so explained. 

The Reason for Profit. — As the risk in the owner- 
ship of the product and the capital goods does not 
explain profit, it is necessary to consider the origin 
and the nature of profit before it can be explained 
why the entrepreneur gets this share. When a 
number of producers bring their products into a 
market, each one will have a more or less accurate 
idea of his cost, below which he will not want to sell. 
The very low-cost producers have no fear because 
they know that any price that- prevails can be 
expected to cover their costs and give them profits. 
The costs of the different producers can be repre- 
sented graphically. The costs shown below are unit 
costs, that is, costs per unit of product, for 10 
producers who manufacture an article of a standard 



PRICE, PROFIT, AND COST 



143 



grade. These producers are assumed to be the only 
producers in the industry. These costs include 
interest. 



'HToW 



mm mw pRow p^m 



PftOFlT PROFIT ^ROHT 



J JLMUJi'SL'm'miKT 

GRAPHICAL REPKESENTATION OF PROFIT AND LOSS IN RELATION TO COST 
OF PRODUCTION 

Assuming that the production period, for which 
these costs are shown, is a normal one, the producer 
whose cost just equals price is defined as the 
marginal producer. Why price was assumed to fall 
just where it did will be explained in the next para- 
graph. The marginal producer, II, made no profit; 
the very highest cost producer, I, showed a loss. 
Each of the eight producers, whose costs were less 
than that of the marginal producer, made a profit, 
which varied inversely with the size of his cost. It 
appears, therefore, that profit was realized by reduc- 
ing cost below marginal cost or price. 

It is interesting to consider the relation between 
productivity and the reduction of cost. It has been 
shown that the lowest-cost producer earns the high- 
est profit, that the highest-cost producer earns the 
least profit, and that differences in profit are com- 
monly explained by ability or luck in the reduction of 
cost. The productivity theory maintains that the 



144 ECONOMICS FOR THE ACCOUNTANT 

most productive entrepreneur tends to receive the 
greatest profit and vice versa. Therefore, if the two 
explanations of profit are consistent, the lowest-cost 
entrepreneur would be the most productive entre- 
preneur. This is theoretically true and can he ex- 
plained by an example. 

If two entrepreneurs had costs of $100,000 each, 
but one produced 1,000,000 units of product and the 
other only 900,000 units, the first would have the 
lower cost and be the more productive. Thus, the 
lowest-cost producer is the producer who gets the 
largest quantity of product per dollar of money 
expended in cost. 

It has been assumed that price covered the costs 
of most of the producers. However, if the demand 
for the article produced had faUen off because of the 
introduction of a substitute or for any other reason, 
the price might have fallen so low as to have equaled 
the cost of producer IV on page 143. If, by any 
chance, these producers had produced very much 
more than the market demanded, price would never 
have been maintained at the cost of the marginal 
producer. When price falls very much below 
marginal cost, considerable losses are incurred. In 
the next production period, the existing producers 
may curtail output or some, who suffered heavy loss, 
may even have to withdraw from the industry. Then, 
when supply is reduced and demand decreased no 
further, price rises and may even cover the cost of 
highest-cost producer, I. During the "World War 
when the supply of commodities was so short and 
the demand was so great, prices rose high above 



PRICE, PROFIT, AND COST 145 

marginal costs, and profits were abnormally large. 

The entrepreneur 's profit is not always explained, 
then, by the fact that his cost is below the marginal 
cost but also by the maladjustment of supply and 
demand and by the divergence of price from 
marginal cost. When producers get together and fix 
prices above marginal cost or when the supply is 
short relative to the demand, profits are earned by 
the marginal producer who, in normal periods and 
under conditions of competition, is supposed to 
receive no profits. Again, a producer can advertise 
an ordinary article in such a way that the consumer 
will be willing to pay a higher price for it than for 
unadvertised articles of the same grade. 

Principal Kinds of Profit. — It is now possible to 
classify the different kinds of profit that the entre- 
preneur receives. First, he can obtain profit by 
selling some of his capital goods, land, materials, 
machinery, etc., for more than they cost. Second, he 
can obtain profit when his price is above marginal 
cost. Third, he can make a profit by having a lower 
cost than that of the marginal producer. The third 
method is the most important and the most perma- 
nent. It is necessary, therefore, to consider what en- 
titles the entrepreneur to this kind of profit. 

From the foregoing analysis it might seem that 
the profit is the result of the entrepreneur 's product- 
ivity. It is sometimes stated the entrepreneur's 
profit arises merely because he underpays his labor- 
ers and because he deprives the capitalist and the 
landowner of what belongs to them. In other words, 
profit is said to exist only when the wages paid are 



146 ECONOMICS FOR THE ACCOUNTANT 

less than the productivity of the laborers, etc. As a 
matter of fact, if the specific productivity of labor 
could be ascertained, it would have to be admitted 
that what the laborers ' efforts seem to produce may 
be in part due to the situation in which the entre- 
preneur places them. If an entrepreneur, not his 
agents, places the laborers in a position where their 
productivities are increased, he may be considered 
responsible for a part of the product that they may 
seem to produce independently. 

It has been pointed out by some economists that 
the entrepreneur is seldom directly responsible for 
any increase in the productivities of the other factors 
and that his managers, efficiency experts, and ac- 
countants should be given the credit of reducing cost. 
This is undoubtedly true and should argue for a 
profit-sharing or bonus system especially for the 
more important employees. In corporations, which 
are the most important type of business organization 
to-day, the common stockholders are the entrepren- 
eur. In most of the important corporations, the or- 
dinary common stockholder has very little to say or 
to do, except to lend his capital, which he does as 
capitalist not as entrepreneur. If the common stock- 
holder actually works, that is, labors, he receives a 
salary in cost and he could hardly claim additional 
profit for his personal service, particularly if the 
salary allowed were sufficient. It must be empha- 
sized that the profit, the dividend minus pure inter- 
est, obtained by the ordinary common stockholder, 
who merely signs a proxy, is seldom productivity 
profit but is given him because he is willing to lend 



PRICE, PROFIT, AND COST 147 

his capital without rigid interest requirements. He 
foregoes the rigid interest requirements in order to 
be allowed to participate in the profits when earned. 

The original stockholders of a company often have 
an idea that is productive and that reduces cost, and 
even though they may give no personal service and 
may actually work in other corporations, they may 
be said to earn their profit. But there are many 
kinds of profits that are not easily justified. Wher- 
ever trade-union organization is not effective, it is 
evident that the entrepreneur's superior bargaining 
power will enable him to pay lower wages than the 
productivities of his laborers would justify. The 
profits that result from the sale of capital goods or 
from inflated prices are often the result of luck, but 
it must be conceded that the profit that is caused by 
a short supply or an increased demand is often due 
to the entrepreneur's judgment of a future market 
and that the service he performs in producing for 
such a market deserves profit. 

The Relation between Price and Cost. — The rela- 
tion between price and cost shows clearly that the 
entrepreneur cannot merely add a certain percentage 
of his investment to his cost in order to determine 
his selling price. A competitively fixed price may 
allow the low-cost producer as much as 50 per cent 
on his investment, whereas it may allow a high-cost 
producer less than one per cent. There is, however, 
an interesting relation between the total investment 
and the gross profit, or economic interest plus profit, 
for the industry as a whole. It can be set forth best 
by presenting the results of a statistical study made 



148 ECONOMICS FOR THE ACCOUNTANT 

in the Qiuirterly Journal of Economics, of February, 
1921. 

Six industries, for which cost data had been col- 
lected, were considered in this analysis. For some 
of these industries costs for only one year were pub- 
lished, whereas in other industries costs for as many 
as four years were available. It was found that, for 
the industries considered, price approximated bulk- 
line or marginal cost when the total gross profit, 
interest plus profit, of all the producers represented 
from about 9 to 12 per cent of their total invest- 
ment and that price was below or above bulk-line 
cost when the industry's gross profit on investment 
was less or more than from about 9 to 12 per cent 
of the industry's investment. By "bulk-line" cost 
was meant the cost below which the bulk of the 
production occurred. Thus, in Table I below, 
Group III is the group in which the average cost, 
$32.21, fell, but it is not the bulk-line group and 
$32.21 is not the bulk-line cost. Group V is the bulk- 
line group because the costs between $36 and $40 
are just high enough to cover the costs at which the 
bulk of the output was produced. It should be noted 
that the bulk-line group is not the highest cost group. 
The highest cost group in the following table would 
have added so little to the product that the bulk 
thereof is accounted for without considering it. 
Tables I and II opposite illustrate this principle. 

The bulk-line producers showed costs of from 
about $36 to $40. Adding an estimated interest of 
$4.30, because the costs in this table include no inter- 
est, it is evident that the bulk-line cost was above 



PRICE, PROFIT, AND COST 149 

I. The Cost op Producing a Ton of News-Print Paper in 1915 



Cost Groups 


Number 
of Mills 


Tons 
Produced 


Per Cent 
of Total 


Average 

Cost 
per ton 


I. Less than $27 


3 
2 
8 
11 
8 
3 


195,820 
138,934 
260,505 
276,672 
120,199 
33,321 


19.1 
13.5 
25.4 
27.0 
11.7 
3.3 


$26 64 


II. $27 and less than $30. 

III. $30 and less than $33. 

IV. $33 and less than $36. 
V. $36 and less than $40. 

VI. $40 and over 


28.51 
31.64 
34.75 
37.74 
43.67 




35 


1,025,461 


100.0 


$32.21 



the average price received, which in 1915 was only 
$38.45. However, the industry only earned about 
six per cent gross profit on its investment in 1915. 



II. The Costs of PuoDticiNa a Pound op Copper in 1918 



Cost less than 15 ff 
Cost 15 to 171 ff 
Cost 171 to 20fi. 
Cost 20 to21jf. 
Cost 21 to 22^. 
Cost 22 to 24^. 
Cost 24 to28ff. 
Cost over 2H ■ ■ 



Total and Average. 



Num- 
ber 
of 

Com- 
panies 



53 



Pounds 
Produced 



424,340,257 
395,672,390 
169,578,109 
36,871,193 
91,812,263 
90,111,068 
33,955,962 
11,426,343 



1,253,767,585 



Per 

Cent 

of 
Total 



33.84 

31.56 

13.53 

2.94 

7.32 

7.19 

2.71 

91 



100.00 



Aver- 
age 

Cost 
per 

pound 



12.630 
16.284 
18.078 
20.477 
21.605 
22.090 
26.273 
35.989 



16.700 



Aver 

age 
Selling 
price 

per 
pound 



357 
430 
073 
664 
108 
207 
455 
172 



24.388 



Aver- 
age 
Invest- 
ment 
per 
pound 



22.428 
33.278 
31.453 
40.419 
36.412 
29.998 
20.961 
93.629 



29.779 



150 ECONOMICS FOR THE ACCOUNTANT 

The average selling prices realized by the pro- 
ducers in the different cost groups varied somewhat; 
but the average selling price for all the companies 
was 24.388 cents. The bulk-line companies received 
approximately 24 cents for their product. The Gov- 
ernment fixed the price of copper at 231/2 cents a 
pound, effective September 21, 1917, and this price 
prevailed until July 2, 1918, when it was put at 26 
cents and remained so for the balance of the year. 

The investment also varied for the different com- 
panies, but it is obvious that the 93.629 cents per 
pound group presented the *' flotsam and jetsam of 
economic life."^ The investment of the bulk-line 
producers was probably somewhere between 20 and 
30 cents. Thus, interest at five per cent would be 
about 1 cent or II/2 cents. If this interest deduction 
be subtracted from the price, the result would be 
anywhere from 22.5 to 23.5 cents. The bulk-line cost 
seems to be about 20 cents. Thus, price was even 
above the bulk-line or marginal costs. This is 
explained by the fact that the industry averaged 
more than 25 per cent on its investment. 

It was stated on page 106 that one reason why it 
seems preferable to have the accountant's cost coin- 
cide with the entrepreneur's cost, rather than the 
entrepreneur-capitalist's cost, would be set forth in 
this chapter. When the accountant excludes inter- 
est from his cost, the difference between price, or 
sales, and cost is ''Gross Profit," that is, interest 
plus profit. Inasmuch as interest bears a definite 

* The highest-cost producers, not the marginal or bulk-line pro- 
ducers. 



PRICE, PROFIT, AND COST 151 

relation to capital or investment, the accountant 
sometimes assumes that the Gross Profit and even 
the pure, or economic, profit also bears a definite 
relation to the producer's investment. This failure 
to distinguish between interest and profit has led 
some accountants to believe that the different per- 
centages of return, gross profit divided into invest- 
ment, obtained from different aggregations of capital 
goods are varying rates of interest on the capital 
invested. Some social-minded accountants have 
gone so far as to believe that if a fixed return of 10 
or 15 per cent gross profit is exceeded, the producer 
becomes a profiteer; they apparently fail to recog- 
nize the desirability of having the producer reduce 
his costs, and they neglect the very important dis- 
tinction between interest and profit.^ 

• See Appendix I. 



CHAPTER XIII 

COMPETITION 

The Assumptions of Competition. — The economic 
organization of society under which we live is often 
called the ' ' competitive system. ' ' In many places in 
the foregoing chapters, '* normal conditions of com- 
petition" were assumed. What is meant by ''com- 
petition"? There are two fundamental principles 
involved: first, every individual is assumed to be 
working for himself by buying what he needs as 
cheaply as possible and by selling what he has for 
as high a price as possible; second, each individual 
is supposed to be working not only for himself but 
also by himself and not in concert with others of 
his class. 

The laborer, the landowner, and the capitalist are 
supposed to charge for what they give in production 
as high a return as they can get. If they are not 
receiving so high a wage, rent, or interest in one 
industry as they could receive in another industry, 
they are supposed to withdraw from the first and 
enter the second industry. The fluidity of labor, 
capital, capital goods, and land, then, is a corollary 
of the first principle of competition. By the fluidity 
of land is meant that if corn does not pay, the acre- 
age may be turned to rye. The entrepreneur, too, 
is supposed to get the best price he can and to go 

152 



COMPETITION 153 

to the most profitable industry. The buyers of eco- 
nomic goods, of which group the consumers are the 
most important members, are assumed to be getting 
the lowest possible prices. 

The second principle assumes that no individual 
in any of the economic classes indicated should com- 
bine with any other individual in his class to 
strengthen his bargaining power. Thus, the laborer 
is supposed to bargain individually with the particu- 
lar entrepreneur for whom he works. The entre- 
preneurs are not supposed to combine in fixing 
prices. 

It is obvious that the assumptions of competition 
are not always valid. The fluidity of labor, capital, 
capital goods, and land is not always so automatic 
as it is believed to be. Laborers, who have acquired 
skill in one occupation, cannot always change their 
crafts on short notice. Many laborers prefer to work 
for their old employers at lower wages than to make 
a change. Capital, which has been transferred into 
fixed capital goods, cannot be shifted readily from 
one industry to another. Swords cannot literally be 
made into plowshares. Moreover, ignorance and 
carelessness may explain much of the immobility of 
the factors of production. 

The producer does not always get the market 
price, particularly if he is located at a great distance 
from the market. The consumer through ignorance 
or through unwillingness and inability to **shop" 
may pay too much for a particular brand. The con- 
sumer, to-day, is forced to place too much depend- 
ence on the seller's advertisement. The trade, as a 



154 ECONOMICS FOR THE ACCOUNTANT 

whole, under the supervision of a governmental 
agency might be required to submit the products 
manufactured to the test of experts, and a standard- 
ization could be based thereon. The Bureau of 
Markets of the Department of Agriculture is 
attempting to establish grades and to preach 
standardization in food products. 

Collective Baxgaimng. — All of these interferences 
with the free play of competition are generally recog- 
nized by economists, but are considered only tempor- 
ary and incidental interferences, which do not affect 
the broad, general principles involved. None of 
these interferences, however, are so noteworthy as 
the fallacy involved in the belief that free, absolutely 
unrestricted competition tends to give to each factor 
of production what can be specifically imputed to 
that factor's service. Such a theory would imply 
that the bargaining power of the entrepreneur and 
the laborer are equal. The greater wealth of the 
entrepreneurs and the fact that there are many more 
laborers than entrepreneurs would enable the entre- 
preneur to keep a large part of the laborer's produc- 
tivity, were not laborers organized. Collective 
bargaining theoretically enables the laborer to get 
what he produces, whereas unrestricted competition 
would probably not give it to him. If collective 
bargaining gives the laborer more than he produces, 
it might be considered uneconomical, according to 
the productivity theory. However, it was suggested 
on page 40 in Chapter IV that it might be advisable 
and even ethical to allow laborers more than their 
specific productivities, even though it might retard 



COMPETITION 155 

slightly the growth of capital and the development 
of enterprise. It has been explained that the econ- 
omist's first interest is in the consumer. However, 
it has come to be realized that even though collec- 
tive bargaining may lead to higher wages, higher 
costs, and higher prices, the laborer needs as much 
attention as the consumer, particularly if the non- 
union and unorganized workers be classed with the 
organized workers, because the incomes of the great 
bulk of the consumers are wages. 

Price Control. — There is another interference with 
free competition that the economist does not con- 
sider so favorably, namely, price control by pro- 
ducers. It was explained in Chapter XII that price 
tends to be equal to the cost of the bulk-line pro- 
ducers under normal conditions of competition. If 
the producers in an industry combined to fix a price 
above the marginal or bulk-line cost, they could 
maintain it, provided the demand were not seriously 
affected. The producers usually fix prices in their 
trade association meetings. Under the guise of 
cost discussion, they often determine upon selling 
prices. The Federal Trade Commission has investi- 
gated the price-fixing activities of some of the State 
canning associations in the Middle "West. The fol- 
lowing paragraphs are taken from the Commission's 
report :^ 

The Iowa and ■Wisconsin associations apparently went 
farthest in price discussions and agreements. An extract 
from the minutes of the meeting of the Iowa association on 

*Eeport of the Federal Trade Commission on Canned Foods, May 
15, 1918. Government Printing Office, Washington. 



156 ECONOMICS FOR THE ACCOUNTANT 

September 27, 1916, runs as follows: "It was, however, the 
general opinion that it is advisable not to open prices until 
after the annual meeting in November, and possibly not 
before the first of the year." Of the meeting of January 
3, 1917, the secretary in his report dated November 6, 1917, 
said: 

After the first of January ... we felt it was time to 
offer goods for future delivery, and based on our estimate 
of such costs, we felt that 90 cents for standard corn was as 
cheap as we could pack it . . . Most Iowa packers offered 
goods at that price. There was no collusion or agreement 
of any kind between packers, but simply a general con- 
sensus of opinion that we could not afford to sell it cheaper. 
This was, I think at least 15 cents per dozen higher than 
any opening price, . . . and it seemed doubtful if the trade 
would accept it. But it remained to be proven that we can 
make a reasonable price, even if it he JiigJier than all 
precedent, and sell our product at that price. 

Rule 5 of the Iowa association, to which all members have 
agreed, reads: "We agree that we will not offer to sell 
future corn any year before a meeting is held by the associa- 
tion, called specifically to discuss the opportune time for 
opening futures." 

The Commission is in possession of copies of letters show- 
ing that members of this association reached agreements as 
to prices, as to time when prices were to be advanced, and 
showing activity of the secretary in holding members in 
line on prices and in inducing members with low prices to 
withdraw them and make quotations in line with those of 
other Iowa packers. The secretary has even gone so far as 
to offer to purchase the product of canners who have made 
low prices, and this secretary stated to an examiner of the 
Federal Trade Commission that this procedure has gen- 
erally been effective. 

In some industries there is no need for the con- 
certed action of a large number of producers because 

* The Commission 's italics. 



COMPETITION 157 

there is only one producer, who has survived or com- 
bined all the others. Such a producer is said to have 
a monopoly. A business unit might be organized 
for the purpose of producing a patented article; if 
no other company had the right to use the patent, 
a monopoly would be inevitable. But there are 
monopolies that have developed in competitive 
industries and not as the result of any patent. 

Large-Scale Production. — It has been said that 
there is a tendency toward monopoly even in a com- 
petitive industry. In order to explain this seeming 
paradox, it will be helpful to consider the probable 
differences between the costs of the large producers 
and the costs of the small producers. If Company 
A manufactures twice as much product as Company 
B, the total Raw-Material cost of Company A will 
probably be twice as great as Company B's Raw- 
Material cost. The Labor cost (Wages) may or 
may not be twice as large for the first company. It 
would undoubtedly take more laborers to double the 
production, but if it did not take twice the number, 
the labor cost per unit of product would be less for 
Company A than for Company B. Even if Company 
A has twice as large a payroll as Company B, the 
overhead costs and all the costs above the prime 
cost, that is, above materials and direct wages, 
would probably be very little greater for the larger 
company. Thus, other things being equal. Company 
A would probably have a smaller cost per unit 
of product manufactured than Company B. More- 
over, even if Company A's production were in- 
creased so that a larger total investment and a 



158 ECONOMICS FOR THE ACCOUNTANT 

larger overhead were needed to handle the increased 
output, the unit cost, nevertheless, might be further 
decreased. The following figures will help to clarify 
the text: 





Company A 


Company B 


Production 


2,000,000 units 


1,000,000 units 






Raw-Material Cost 


$2,000,000 
1,000,000 
1,000,000 


$1,000,000 


Labor Cost 


500,000 


Overhead Cost 


750,000 






Total Cost 


$4,000,000 
$ 2 


$2,250,000 


Cost per unit 


$ 2.25 







The unit Eaw Material and Labor costs were identi- 
cal but the Overhead was $0.50 for Company A and 
$0.75 for Company B. 

What has been described in the foregoing para- 
graph is predicated on an assumption of economic 
theory known as the law of increasing returns. As 
the production is increased, and as new units of 
labor and capital, represented by capital goods and 
land, are added, the unit cost of production is 
decreased. However, in almost any type of business, 
there is a limit beyond which additional units of 
labor and capital goods can be added economically. 
"When the addition of these units increases the pro- 
duction but does not decrease the unit cost, or, in 
other words, when the new units of labor and capital 
just pay for themselves, the law of constant return 
is said to be operating. There might come a time 



COMPETITION 159 

when additional nnits of labor and capital would 
not pay for themselves, when the unit cost would be 
increased rather than decreased as a result of the 
increased production. Then, the law of decreasing 
return would be operating. 

It is generally held that the law of decreasing or 
diminishing return begins to operate sooner in 
agriculture and in the extractive industries than in 
manufacturing or in marketing. When the farmer 
first hires new laborers and buys additional farm 
machinery, the product will probably be increased 
in sufficient quantities to pay for the increased 
wages, for the depreciation on the new machinery, 
and the interest on the capital used to obtain the 
machinery and to finance the extended operations. 
However, if the farmer continues to add more labor, 
to use more capital, and to obtain more capital goods, 
a time will come when the increased quantities pro- 
duced will not compensate for the increased 
expenses, such as wages, depreciation, and interest. 
Under such circumstances, the law of diminishing 
return has begun to operate. The farmer, then, 
looks to new land if he would increase his product. 
In agriculture, this law has resulted in a limit to 
*' intensive cultivation" and has encouraged ''exten- 
sive cultivation." 

Inasmuch as the operations of the law of increas- 
ing return, according to pure economic theory, is 
supposed to apply to most manufacturing establish- 
ments, it would seem that the largest business units 
would have the lowest cost.^ Futhermore, since the 

* See the foregoing paragraphs. 



160 ECONOMICS FOR THE ACCOUNTANT 

large low-cost company would reinvest its profits 
and expand, its costs would be further reduced. If 
it reduced prices so as to obtain new customers, it 
might eventually drive out all competitors. This 
explains the seeming paradox that there is a tend- 
ency toward monopoly even in competition. 

There are certain interesting qualifications that 
might be appended to the theory advanced in the 
foregoing paragraph. There is often a limit to the 
size of the most efficient business unit. In other 
words the law of increasing returns does not always 
operate without qualification even in a manufactur- 
ing industry. Furthermore, the largest company does 
not always have the lowest cost; it may maintain its 
relative importance in the industry by methods that 
will be explained in subsequent paragraphs. Fin- 
ally, because cost is dependent on many different 
physical and psychological factors, a low-cost com- 
pany in one year may become a high-cost company 
in another year. 

Obviously the relation between the size of the 
business unit and cost would be different for dif- 
ferent industries. Statistical studies will have to 
be made, however, before this relation can be 
definitely established. The unwillingness of pro- 
ducers to T-eveal their costs, as well as the great 
expense involved in securing them, makes such 
studies practically impossible for any agency other 
than the Federal Government. In the Federal Trade 
Conmiission's Report on Canned Salmon, December, 
1919, it was shown that the larger plants had lower 
costs than the smaller plants but that the larger 



COMPETITION 161 

companies, whicli were merely combinations of a 
number of plants, some large and some small, bad 
bigher costs tban some of tbe smaller companies, 
wbicb might have had only one large plant. It 
might have been thought that the large company, 
which was merely a combination of small plants, 
would have the advantage of economy in buying 
materials and would have had a lower General and 
Administrative Expense per unit of product. 

Unfair Competition and the Anti-Trnst Legisla- 
tion. — There are many advantages that the large 
company has even though some of the smaller com- 
panies may have lower costs. The large company 
with great capital can advertise its product and 
obtain a profit, that does not result from reduced 
cost.* Some manufacturers, who are not nationally 
advertised, have to sell their brands at prices under 
the prices of the nationally advertised brands. The 
large company, moreover, can stand the strain of 
demoralized prices better than the small company. 
In fact, some large companies have been known to 
depress their prices below all costs for a period in 
order to embarrass their weaker and smaller com- 
petitors. The large companies have often monopo- 
lized the sources of supply of raw materials, or, 
through control of transportation, have obviated 
competition.^ Secret rebating as well as numerous 
other unfair methods of competition have also led 
to monopoly. 



* See page 145. 

^ See Summary to the Federal Trade Commission 'g Eeport on the 
Meat-Paeking Industry. 



162 ECONOMICS FOR THE ACCOUNTANT 

When industry began to develop in the United 
States after the Civil War, producers often found it 
advantageous to make agreements with each other 
rather than compete. Moreover, as business men 
came to realize the advantages of large-scale produc- 
tion and the profits to be made by eliminating com- 
petition, they began to combine their businesses. The 
promoter's profits in such combinations attracted a 
certain type of men with organizing ability, who 
attempted to combine everything there was to be 
combined. In 1890 Congress enacted the Sherman 
Anti-Trust Law, which made any monopoly, at- 
tempted monopoly, or restraint of trade illegal. 
By ''restraint of trade" was probably meant any 
interference with competition. Most of the combina- 
tions had been affected through what were known 
as trusts. Every stockholder of the companies com- 
bined had surrendered his voting power to a group 
of trustees, who gave him trust certificates in return. 
The holders of the trust certificates received the 
dividends, but the control was vested in trustees, 
who voted the stock. The Sherman Law declared 
these ''trusts'^ illegal. 

Not very much attention was given to this law 
until between 1900 and 1905, when a large number 
of the combinations that had been formed began to 
fail.^ These failures were probably due to the fact 
that competition had not been effectively stifled and 
that the combination of plants and companies was 
often less efficient than the separate units that com- 

• See A. S, Dewing, Corporate Promotions and Reorganization, 
Harvard University Press, 1914. 



COMPETITION 163 

posed it. These failures and rising prices stirred up 
feeling against combination and monopoly. The dis- 
solution of the Standard Oil Company of New 
Jersey and the American Tobacco Company in 1911 
sounded a note of warning to those who anticipated 
violating the Sherman Law. However, it is often 
maintained, and with good reason, that the dissolu- 
tion decrees did not really establish competition. 
Although the Standard Oil Company of New Jersey, 
which had controlled the other Standard Oil com- 
panies through the ownership of majorities of their 
stocks, was dissolved, the original stockholders of 
the Standard Oil Company of New Jersey were 
given, as individuals, the controlling stocks of the 
various Standard Oil companies. Thus, the same 
families, such as the Eockef eller, Harkness, Flagler, 
Whitney families, etc., who formerly controlled the 
Standard Oil Company of New Jersey and, through 
it, all the subsidiaries, to-day control the subsidiaries 
directly. That there can be any real competition 
between these subsidiaries, that is, between the dif- 
ferent Standard Oil companies, seems improbable. 
In 1914 the Clayton Act and the Federal Trade 
Commission Act were passed by Congress to check 
incipient monopoly. The Sherman Law had only 
made monopoly or attempted monopoly illegal. The 
Clayton Act made any combination that *' substan- 
tially lessened competition" unlawful. A company, 
thus, was not allowed to buy the stock of its com- 
petitor, even though the two companies together 
controlled only one per cent of the total production 
of the industry, if the purchase lessened competition 



164 ECONOMICS FOR THE ACCOUNTANT 

between them. Furthermore, price determination as 
between different purchasers was declared illegal. 
The Federal Trade Commission Act created a body 
that was given authority to declare unfair methods 
of competition unlawful. It was believed that secret 
rebating, misbranding, price discrimination, and 
other unfair methods of competition would enable 
companies that used them to crush their competitors. 
Therefore, the Federal Trade Commission is author- 
ized to investigate all suspicious trade practices and 
to decide, subject to later revision by the courts, 
what methods of competition are unfair and should 
be declared unlawful. 



CHAPTER XIV 

TAXATION 

Man's Political Relations. — In all of the foregoing 
chapters man has been considered in his economic 
relations only. Because all are consumers, and in 
order to be consumers must give aid in production 
or receive support from those who do, all have an 
economic relation and are a part of the economic 
organization of society. But everyone also has a 
political relation and is a part of the state. For- 
merly, there were two classes: the governors and 
the governed; but in modern democracy every man 
is supposed to have something to say about how he 
is governed. The government, therefore, is created 
in the state and by the people of the state to manage 
its affairs. 

The student of economics will readily see the need 
of government. Competition presupposes rivalries, 
conflicts of interest, and cross-purposes in the recon- 
ciliation of which a government and governmental 
machinery are necessary. Furthermore, the govern- 
ment is needed to do certain definite things that 
individuals could not or would not do, as for example 
public-health service. Finally, a government has 
always been expected to protect its people from the 
aggressions of other peoples. 

It was stated in Chapter I that a German econ- 

165 



166 ECONOMICS FOR THE ACCOUNTANT 

omist had criticised American economists because 
they do not pay sufficient attention to the relation 
of the state to man's economic welfare. Most 
American and English economists have believed for 
many years in a laissez-faire policy for the govern- 
ment. In other words they have believed that the 
government should interfere as little as possible 
with men in their economic activities. Moreover, 
many of them have believed that the government 
should do as little as possible. It will be shown that 
these theories of government have an important 
bearing on the problem of taxation. 

The Purposes of Taxation. — It is evident that if 
a government does anything at all, it must have 
funds. These funds are usually obtained through 
taxation.^ C. F. Bastable, the English economist, 
defines a tax as "a compulsory contribution of the 
wealth of a person or body of persons for the service 
of the public power." Those who think that the 
government should do as little as possible would 
probably believe in the lightest taxes possible. They 
would be inclined to oppose any taxes but those 
absolutely necessary for the simplest kind of govern- 
mental machinery. For them the only purpose of 
a tax would be the financial support of the govern- 
ment. 

A tax may have one or two other purposes than 
the one mentioned. (1) Certain forms of taxation 
are often proposed as methods of redistributing 

* These funds, however, might be obtained from rents paid by those 
who lease the public domain or government lands, or they might be 
secured by the government's business activities, such as running the 
railroads, etc. 



TAXATION 167 

wealth. The inheritance tax, for example, might be 
used to take from those who have too much and to 
help those who have too little. Obviously, if the 
government, Federal or State, imposed a larger tax 
on inheritances, the proceeds would be sufficient to 
obviate certain other taxes, which might be paid by 
those who can less well afford to contribute to the 
state's support than the beneficiaries of inheritances. 
(2) Some taxes have been proposed primarily for 
the accomplishment of some especial purpose. The 
tax on State banknotes and on oleomargarine were 
imposed primarily to obviate their existence. The 
taxes on whiskey and tobacco may have had some- 
what the same purpose, but they were also used 
for the revenue they yielded. This was also true of 
the protective tariff, which kept out certain foreign 
products and stimulated American industries, but 
which was also an important revenue-yielding tax. 

Most fiscal systems employed by governments 
to-day include all kinds of taxes, most of which 
have been imposed for more than one reason. Even 
those taxes, that have been levied primarily for 
revenue, have often been imposed in such a way as 
to put the least burden on the poor and heavier 
burdens on those who could better afford to bear 
them. This method of imposing taxation, however, 
has not been evolved primarily for the purpose of 
redistributing wealth but because taxation seems 
less burdensome when those who can best afford to 
pay are taxed most. 

The Single Tax. — The single tax has been pro- 
posed by social reformers as a means of redistribut- 



168 ECONOMICS FOR THE ACCOUNTANT 

ing wealth. The name of Henry George nsnally has 
been associated with this tax in the United States 
but the French Physiocrats had somewhat the same 
idea back in the eighteenth centnry. The single tax, 
as conceived by Henry George and the Physiocrats, 
was to be a tax on land and rent. All of the state's 
revenues were to be obtained from this tax. There 
are probably two considerations that led to this pro- 
posal: first, land is not produced by man's efforts 
and rent from the use of land seems unjustified; 
second, land increases in value because of the growth 
of population and through no effort on the part of 
the landowner. Even though there might seem to 
be no justification for allowing a man to claim a 
piece of land as his own, because he did not produce 
it, it is clear that after the first transfer, it would be 
easy to justify ownership and rent, especially if the 
purchaser had saved out of his wages the capital 
necessary to make the purchase. Moreover, the rent 
demanded by the first owner is not large pay for the 
hardships of frontier life. The taxation of unearned 
increments in land values, which is being developed 
particularly in municipal finance, meets the second 
problem of the single taxer. Furthermore, the 
income and profit taxes are probably the most effec- 
tive way of reaching this source of taxation. It 
should be noted that there are many imearned 
increments other than in land values, as for example, 
the appreciation in the value of other capital goods, 
inheritances, and other kinds of profits.^ The single 
tax would neglect all these, and would give undue 

« See Chapter XII. 



TAXATION 169 

emphasis to unearned increments in land values. 
This tax has never been tried on a large scale, and 
has probably even lost vogue as a method of social 
reform since the spread of Socialism. 

It is doubtful whether taxation has ever been used 
to any great extent merely for the redistribution of 
wealth. A government needs funds and taxes the 
citizens or the institutions of the state in order to 
obtain them. In imposing taxes, it may consider on 
whom the taxes will fall, that is, who actually pays 
them, and it may attempt to have them fall most 
heavily on those who can best afford to pay them. 
If this principle is carried very far, and if the gov- 
ernment uses the proceeds from such taxes to 
improve the condition of the poor, taxation is 
incidentally being used to redistribute wealth. 

The Shifting and Incidence of Taxation. — The fact 
that many taxes that seem to be paid by one class 
are really paid by another has stimulated the econ- 
omist's interest in the ''shifting and incidence" of 
taxation, or in how a tax may be shifted by those on 
whom it is imposed to others on whom it falls 
(incidence). It has been explained that a tax on 
imports will be shifted by the importer to the con- 
sumer. If an article were produced in the United 
States at costs ranging from $4.50 to $5.20 and sold 
at about $5.10, the same article produced in Ger- 
many at costs from $3.50 to $4.00 would, at a price of 
about $4.00, including freight, supplant a part or 
all of our American-made product. If a tariff of a 
dollar were imposed, the German and the American 
product would compete. The importer would pay 



170 ECONOMICS FOR THE ACCOUNTANT 

$4.00 for the German product and $1.00 tariff, but 
he would be able to charge the consumer about $5.10. 
Thus, he would shift the tax to the consumer. If 
the article were not manufactured in the United 
States, the importer would be able to shift the tax 
and probably be able to include an even greater 
margin of profit in his selling price. 

The Income and Profit Taxes. — Most of the rev- 
enue of our Federal Government has been derived 
from the income tax since 1916. Congress had estab- 
lished an income tax in 1894 but the Supreme Court 
had declared it unconstitutional. An amendment to 
the Constitution allowing Congress to levy an income 
tax was passed in 1909 and ratified by the necessary 
number of States in 1913. The Act of 1913 imposed 
an ordinary tax of one per cent on all incomes over 
$3,000 and $4,000 for a married couple, and a 
graduated surtax, ranging from one to six per cent, 
on incomes over $20,000. The highest rate applied to 
incomes over $500,000. The ordinary tax was col- 
lected from all corporations; the stockholders as 
individuals, thus, were exempted from paying it. 
In 1916 the ordinary rate was increased to two per 
cent and the rates of the surtax were fixed at froin 
1 to 13 per cent. 

When the United States entered the War in 1917, 
the War Eevenue Act revised the income tax. The 
normal rates were doubled and a four per cent tax 
was levied on corporations. In addition to the sur- 
tax, 1 to 13 per cent, a war surtax on incomes over 
$5,000 was imposed with rates from 1 to 50 per cent. 
In 1919 the income-tax law was revised so there was 



TAXATION 171 

just one set of normal and surtax rates. Under this 
law of 1919, incomes over $1,000, or $2,000 for a 
married couple, were taxed. On incomes from $1,000 
to $5,000 the normal tax was 6 per cent, and on 
incomes over $5,000 it was 12 per cent. The surtax, 
which was imposed only on incomes over $5,000, 
ranged from 1 per cent up to 65 per cent. The last 
rate applied to any income over $1,000,000. 

The great profits due to the high prices, which 
prevailed during the War, were taxed by what is 
known as the excess-profits tax. All businesses, which 
earned a gross profit, or interest plus profit, in excess 
of a certain percentage of the capital invested, fixed 
at eight per cent, paid taxes varying from 20 to 60 
per cent according to the rates of gross profit earned 
on investment. Thus, if a business earned anywhere 
from 8 to 15 per cent gross profit, it paid a tax of 
20 per cent; if the gross profit was from 15 to 20 
per cent, it paid a tax of 25 per cent, etc. 

In 1919 this excess-profits tax was revised. A new 
tax, known as the war-profits tax, was imposed as 
an alternative. This tax was fixed at 80 per cent of 
the amount of difference between the income of a 
pre-war period and of the year for which the tax was 
levied. The excess-profits and the war-profits taxes 
were both to be computed, and whichever was larger 
was to be paid. 

Although the income tax was levied on incomes, 
which were received as wages, rent, interest, or 
profit, the profits taxes were levied directly on the 
entrepreneur's share. The incidence of a tax on 
profits is a problem of great interest to both the 



172 ECONOMICS FOR THE ACCOUNTANT 

economist and the accountant. It has been shown 
that in a normal period price is fixed at the bulk- 
line producer's cost. The bulk-line producer, how- 
ever, just receives interest but earns no profit; he, 
therefore, pays no tax. The producers with costs 
lower than that of the bulk-line man must pay the 
tax out of the profit that competition would allow 
them, if it be assumed that they cannot lift the price 
above the bulk-line cost. Thus, price would not be 
affected and the producer, not the consumer, would 
be forced to shoulder the tax. 

In a period of inflated prices, when price is far 
above the bulk-line costs, all producers, even the 
highest-cost producers, would make a profit and have 
a tax to pay. The high-cost producers, as well as 
the low-cost producers, would be able to shift price 
up so to cover the profits tax or a part of it. There- 
fore, during the War, when the demand justified any 
prices and when prices were high above all costs, 
the profit taxes were probably shifted to the con- 
sumer. The fact that profits taxes were shifted to 
the consumer during the War was used against them 
by many who argued for a sales tax. The difficulty 
of determining the profit for business organizations, 
the publicity it gave to war profits, and the burden 
it imposed on entrepreneurs were the real motives 
that were behind the opposition to the income and 
profit taxes. The sales tax can be shifted to the 
consumer in normal as well as abnormal times but 
the possibility of shifting a tax on profits is far more 
limited. The marginal, as well as the lower-cost, 
producers will pay the sales tax; they will add it to 



TAXATION 173 

cost and probably succeed in shifting it to the con- 
sumer. 

There is an interesting question as to whether the 
accountant should include the tax on profits in cost. 
Obviously the bulk-line producer would have no such 
tax in his cost, because he would have none to pay. 
Furthermore, the tax could not be included in cost 
when profit is being determined, because its inclu- 
sion would presuppose that profit was already 
determined.^ It is a tax based on profit. However, 
after it is determined, that is, after price is fixed, 
it might very well be added to the other costs or 
monetary sacrifices of the entrepreneur. But if the 
cost is to be used by the entrepreneur merely as a 
basis for fixing a price, it should not include the 
profit tax. Furthermore, in determining cost for 
the purpose of computing the profit tax to be paid, 
it would be absurd and logically impossible to 
attempt to include such a tax.* 

*See Appendix 11. 
* See Appendix II. 



APPENDICES 



APPENDIX I 

INTEREST AS A PART OP COST 

The problem of whether interest should be 
included in cost is much debated by accountants, 
but the solution of this problem is so dependent 
upon a knowledge of economic theory that much 
that has been written and said is either illogical or 
irrelevant. This question has been referred to in a 
number of places in this book, but it seems advisable 
to set forth a complete discussion of the problem in 
this appendix. 

It has been explained that the accountant is 
working for the entrepreneur and that accounting 
cost is practically the entrepreneur's cost.^ Just 
who the entrepreneur is and what he does has also 
been discussed in detail on page 137. In a corpora- 
tion, the most common form of business organization, 
the common stockholders are the entrepreneur and 
in a single proprietorship or partnership, the pro- 
prietor or partners. The entrepreneur has the vot- 
ing control and he is owner of the capital goods and 
product. The entrepreneur may or may not be the 
capitalist. The capitalist supplies the capital, which 
is defined as postponed claims on consumption goods, 
expressed in terms of money. The entrepreneur 

* Accounting costs are actually the entrepreneur's costs that can be 
established before sale. 

177 



178 ECONOMICS FOR THE ACCOUNTANT 

takes these postponed claims and uses them for 
expenses or transfers them into capital goods, which 
are defined as goods used in the production of other 
goods. Although it should be noted that in prac- 
tically all corporations the common stockholders 
supply capital, when they buy their common stock, 
the conunon stockholder can be a pure entrepreneur 
and have no dollar of invested capital in the busi- 
ness.^ Furthermore, even though the function of the 
entrepreneur and the function of capitalist may be 
embodied in the same person, they are, nevertheless, 
separate functions. The shoemaker described on 
page 83 was entrepreneur, capitalist, and laborer. 
Not only should these functions be distinguished but 
the returns received should be differentiated. The 
shoemaker receives profit as entrepreneur, interest 
as capitalist, and wages as laborer. 

It was explained on page 83 that the entrepeneur 's 
sacrifies in his other capacities are as much a part 
of his costs as his actual monetary expenditures. 
Thus, the entrepreneur's costs include an allowance 
for himself as laborer, if he works, and interest on 
his own capital as well as his actual monetary pay- 
ments to hired laborers, to the bankers, and to the 
entrepreneurs, who furnished him with raw ma- 
terials. 

There are certain sacrifices made by the entre- 
preneur, as e7itrepreneur, but such sacrifices are not 
included or compensated for in cost, even if they 
could be measured in money. Thus, the undertaker 
may be making a sacrifice in engaging in his profes- 

*See page 137. 



INTEREST AS A PART OF COST 179 

sion, but lie makes this sacrifice as entrepreneur and 
receives his reward in profit, which theoretically 
would be greater because competition would prob- 
ably be less keen. Even if the distaste of each par- 
ticular entrepreneur could be measured in terms of 
money, it would not be a legitimate part of the 
entrepreneur's cost. Engaging in a distasteful 
occupation is one of the functions of an entrepreneur 
who directs funerals, and his profit is the payment 
for this among other things. The undertaker's dis- 
taste is his sacrifice as entrepreneur, not his sacrifice 
as laborer or as capitalist. Now, if the entrepreneur 
receives any return in his capacity of entrepreneur, 
it is his profit and not his cost. 

Obviously if the entrepreneur's cost is being con- 
sidered, his payments of interest to outside capi- 
talists and an interest charge for his own capital 
must be included in his entrepreneurial cost. He, 
as entrepreneur, owes himself as capitalist inter- 
est just in the same way that he owes himself a 
salary as laborer, if he works. It might be urged 
that an entrepreneur must have capital in order to 
be an entrepreneur, and that the interest he receives 
is no different from profit in that it is a return for 
one of his necessary entrepreneurial functions. But 
it was explained on page 137 that there can be a pure 
entrepreneur and it must be realized that inventors 
are often pure entrepreneurs when they take the 
common stock of the enterprise and sell preferred 
stock to outside capitalists. That the entrepreneur 
of a corporation, the stockholder, is usually both 
entrepreneur and capitalist has led most accountants 



180 ECONOMICS FOR THE ACCOUNTANT 

to insist that their return cannot be subdivided into 
interest and profit. However, some members of the 
profession realize that interest actually paid on 
short-term loans, on notes, or on bonds are actual 
expense in the same way that wages paid to laborers 
and rent are expense. For another reason some 
accountants include interest on short-term notes 
although interest on capital, borrowed for longer 
than a year, is excluded.^ 

There is one argument of some interest for includ- 
ing interest actually payable in cost and excluding 
interest on the stockholders ' investment : the interest 
to outside capitalists has to be paid, whereas the 
interest on the stockholders' capital legally need 
never be paid. Although it will be shown that this 
is no basis for the distinction between what is cost 
and what is not cost, the same argument can be 
used against the inclusion of Salaries and even of 
Depreciation in cost. Although Depreciation repre- 
sents a part of what was spent, legally, it need not 
be set aside. It represents an allowance to take care 
of the capital expended in the purchase of the fixed- 
capital goods (depreciated) but if this capital, or 
a part of it, was supplied by the stockholders, the 
depreciation allowance is no more their obligation 
than the interest payment. The capital could not be 
replaced if Depreciation were not allowed in cost 
or deducted from profits, but the business might go 
on nevertheless; moreover, the entrepreneur-capi- 
talist would hardly be willing to continue if he could 
not even make a sufficient Gross Profit, or interest 

*See pages 127 and 128. 



INTEREST AS A PART OF COST 181 

plus profit, to cover an interest return. In the final 
analysis, however, entrepreneur's cost is not a 
matter of law or judicial decision; it is a total of 
expenditures made to others and allowances for 
sacrifices made by the entrepreneur in his other 
capacities. 

It might be asked what allowance is to be made 
the entrepreneur, if he works. The answer seems 
simple enough: what he is worth. It, then, might 
be argued that a laborer may get less than he is 
worth, and that the laborer's sacrifice is not cost. 
True, but the entrepreneur is in a strategic position 
and he can insist upon his worth in his bargain with 
himself. Furthermore, the accountant must give 
him his worth because the accounting statement is 
made for the entrepreneur. It may be recognized 
that the allowance of salary for entrepreneurs com- 
mensurate with their worth is the accountant's tacit 
assumption of the productivity theory.* It is impor- 
tant to note that the accountant is not interested in 
the laborers' sacrifices except when the laborer hap- 
pens to be the entrepreneur. 

It seems indisputable, then, that if it can be 
assumed that the accountant is determining the 
entrepreneur's cost, interest as well as salaries for 
stockholders who work must be included. However, 
the reasons for assuming that accounting cost must 
coincide with entrepreneur's cost have not been fully 
presented. Before these reasons can be compre- 
hended, a restatement of the purposes of cost is 
necessary. There are four principal needs of know- 

* See Chapter IV. 



182 ECONOMICS FOR THE ACCOUNTANT 

ing unit costs of producing the different sizes and 
grades of commodities handled: (1) for fixing sell- 
ing prices; (2) for determining the different profits 
on the different commodities, after they are sold; 
(3) for comparing the itemized costs of different 
plants and for different years, etc.; and (4) for valu- 
ing inventories. 

It has been explained at great length that seldom 
does the entrepreneur sit at his desk and fix a price; 
he attempts to get the best price he can. However, 
there are two particular reasons for knowing the 
unit costs. When prices are falling or where com- 
petition is very keen, the entrepreneur wants to 
know cost in order to know the lowest possible price 
that will not result in a loss. Obviously, for this 
purpose interest actually paid or payable should be 
considered, for even if he received cost without any 
interest, he might be losing money because he might 
have to pay bond interest, interest to the banks, and 
probably even preferred-stock dividends. Further- 
more, even if he included interest paid but did not 
include interest on his own capital he would not be 
receiving a price that would allow him to be break- 
ing even, because he would be unpaid as capitalist. 
Furthermore, if interest is excluded when competi- 
tion is very keen, one entrepreneur may believe that 
he has a lower cost than the others, whereas his 
lower labor cost, for example, may be due to a 
greater use of machinery, which may have been 
financed by outside capital and require actual inter- 
est payments. 

The accountant may insist that he takes these 



INTEREST AS A PART OF COST 183 

things into consideration even tliongli lie does not 
consider them in connection with cost. Some 
accountants have so limited the conception of pro- 
duction cost that they do not even consider inventory 
adjustments, General and Administrative Expense, 
or Selling Expense. Obviously, for the use of cost 
in connection with price, these considerations must 
not be neglected. The Cost of Sales, rather than the 
Cost of Production, that is. Cost of Production, plus 
the first Inventory, minus the last Inventory, plus 
the General and Administrative Expense, plus Sell- 
ing Expense, must be considered when using cost as 
a basis for price quotation. The accountants who 
oppose the inclusion of interest in the Cost of Sales 
would insist that when selling price is to be con- 
sidered, some allowance can be made for the invest- 
ment, but obviously the best way to treat this invest- 
ment is to include interest in cost. Furthermore, 
this allowance is usually supposed by accountants 
to be a combination of interest and profit, and the 
difference between price and cost, minus interest, is 
often called return on investment. This treatment of 
interest and profit is based on a misconception of the 
nature of these two shares. Profit is not determined 
until the sale is made, but interest is a cost the 
moment capital is injected into the business unit. 
The accountant may object, and urge that interest is 
not always realized. Interest is not "realized" any 
more than wages are "realized"; both wages and 
interest are costs even if the goods are never sold. 
Profit is the only share that is determined by sale." 

■ See Appendix II. 



184 ECONOMICS FOR THE ACCOUNTANT 

The possibility of arriving at an actual Cost of 
Sales on which price can be based may be questioned, 
inasmnch as goods are being sold constantly and an 
accurate Cost of Sales would be difficult to determine 
until the end of the year. However, even if only the 
Cost of Sales of the past year is available, it 
furnishes a basis for estimating the probable present 
cost. 

The second reason given for cost analysis was the 
necessity for determining the different profits on the 
different commodities manufactured. The efficient 
general manager needs to know on which commodity, 
and even on which size or grade of the different com- 
modities, he has realized tli« least profit. The sales 
policy and the emphasis in manufacturing may be 
determined by the different margins of profit re- 
alized. For this purpose it is obvious that the 
investment must be considered. If one commodity 
shows a lower cost than another, it may be due to 
the larger amount of capital invested in the machin- 
ery used in producing the apparently cheaper com- 
modity. The accountant may believe that if interest 
is excluded, the gross margins between the prices 
and the computed costs, that is, interest and profit, 
can be measured on the investments in order to 
determine the profitableness of the various com- 
modities. However, this involves a computation of 
investment, and furnishes a useful basis for compari- 
son, although it too often assumes that profit bears 
a fixed relation to investment.® Too many account- 
ants neglect the matter of investment altogether, and 

• See Chapter XII. 



INTEREST AS A PART OF COST 185 

believe that a comparison of costs, excluding inter- 
est, is all that is needed. The exclusion of interest 
from cost has led to this belief. 

The third reason for cost analysis, for a comparison 
of the costs of different plants, is often admitted as 
a good reason for including interest in cost. If the 
costs of various plants are being compared, some of 
which pay rent, an item of cost, and some of which 
are owned, those that are owned will seem to have 
much lower costs than those that pay rent, whereas 
the efficiencies of the apparently high-cost plants may 
actually be greater than those of the apparently low- 
cost plants. 

The fourth purpose of cost accounting is probably 
the most important from the accountant's point of 
view. The accountant maintains that in computing 
profit, the adjusting inventories of finished goods 
should be valued at cost.'^ 

Therefore, the cost of the finished goods has to be 
determined before they can be valued in the closing 
inventory. Some usually thoughtful accountants 
argue that the inclusion of interest in cost involves 
an interest charge in the inventories. The inventories 
are not sold, they maintain, and therefore they 
believe that interest is not realized. But interest 
may be actually paid, or be payable, and, if not 
actually paid, sacrificed. The labor cost embodied in 
the inventories is not "realized" until they are sold, 
but no one ever doubts but that labor is a cost. 
Neither wages nor interest need to be "'realized" in 
order to be costs; profit is the only share that is 

* See page 133. 



186 ECONOMICS FOR THE ACCOUNTANT 

determined by price and the market, and profit is the 
only share that is ''realized" by the entrepreneur in 
the sense that these accountants use the word. True, 
the interest may not be earned or paid, but that is 
also true of the wages. If interest is logically a part 
of cost, it is highly illogical to object to its inclusion 
in inventories, if they are to be valued at cost. To 
object to interest, assuming that it is logically a cost 
item, because it inflates cost or the valuation of the 
inventories, is like arguing that wages or Deprecia- 
tion should not be considered cost items because 
they increase costs. 

It seems evident that it is the pure entrepreneur's 
cost that the accountant is determining. If the 
accountant refuses to admit this, he is put in the 
position where he must consider his statements com- 
piled for the stockholders, bondliolders, and banks. 
Obviously, he is not making his statements for any 
one other than the common stockholders. On the 
Balance Sheet, for example, the Surplus is not de- 
scribed as the common stockholders' Surplus, but it 
so evidently belongs to them that no specific mention 
is necessary. Every accounting statement is made for 
the common stockholders, who may or may not be 
entrepreneur-capitalist, but who are always entre- 
preneur. If it is contended that the entrepreneur is 
seldom a pure entrepreneur and is usually entre- 
preneur-capitalist, cost without interest would not 
be giving the entrepreneur-capitalist the same con- 
sideration accorded the outside capitalists. Thus, 
the exclusion of all interest to banks, bondholders, 
and stockholders would involve an illogical grouping 



INTEREST AS A PART OF COST 187 

of partners, or stockliolders, and creditors, the banks 
and bondholders, as well as a confusion of profit and 
interest, and the inclusion of interest actually paid, 
along with the exclusion of interest on the stock- 
holders' capital, would be treating the capitalists, 
for whom the statement is made, with less considera- 
tion than the outside capitalists and would make the 
costs arrived at less significant for the reason 
already given in the foregoing pages. 

The method of determining the basis of the inter- 
est charge and the percentage of interest to be 
allowed is as little understood by accountants as the 
theory underlying the problem of interest. It has 
been shown that capital is the basis of interest and 
not the valuation of capital goods. True, the 
original cost of the capital goods is used, but this 
original cost is in no sense their proper valuation 
at any time; the original cost is used because it rep- 
resents the amount of capital poured into the busi- 
ness. Furthermore, it has been explained that no 
revaluations are allowable but that all profits and 
interest, due the stockholders but left in the business, 
are additions to capital. Thus, much of the technic 
involved in computing the interest charge is gener- 
ally understood, although the theoretical reasons 
given by accountants for the use of original cost are 
never satisfying. About the interest rate to be 
charged there is even less cogent reasoning. Obvi- 
ously, the interest rate to be charged should be that 
prevailing at the time the capital was invested. 
When the bondholder invests $1,000 at five per cent, 
he does not expect to receive a higher rate later, even 



188 ECONOMICS FOR THE ACCOUNTANT 

if the interest rate rises. The entrepreneur who 
invests his capital does it with the understanding 
that he has a long-time investment and he should 
calculate interest just as if he were a bondholder. 
If he reinvests some of his profits or interest at a 
later period, the interest allowed on them should be 
charged at the percentage prevailing for that type 
of investment when these profits and interest were 
earned and reinvested, that is, not withdrawn. 

The method outlined for determining the interest 
charge may seem hard to apply but the same may be 
said of the proper method of charging depreciation. 
If the accountant will keep an accurate record of 
interest paid and of a proper interest charge for the 
entrepreneur's capital when invested, there will be 
no difficulty except with the reinvested profits and 
interest. Something concerning the method of treat- 
ing these additions to capital has already been given 
in Chapter XI. For the use of firms that have no 
way of determining what interest rates applied in 
the past, the accountants, with the help of the banks, 
should attempt to compile adequate tables for dif- 
ferent geographical sections and for different indus- 
tries. 

Some accountants find a certain technical difficulty 
in charging interest into cost, but this difficulty 
arises out of the misconception that interest is the 
business organization's income in the same way that 
economic profit is. When a stockholder receives a 
salary, this salary is charged to cost and credited 
to some real account, usually either Cash or the 
stockholder 's personal account. The same procedure 



INTEREST AS A PART OF COST 189 

can be followed in the matter of interest. A real 
account should be credited and cost should be 
charged with the interest on the stockholder's invest- 
ment. The feeling that interest should not be 
credited to a real account has probably been caused 
by the belief that interest is income in the sense that 
profit is income, but this credit is no more illogical 
in the case of interest than in the case of salary. 



APPENDIX n 

CASH DISCOUNTS ON SALES, BAD DEBTS, OUTWARD FREIGHT, 
DONATIONS, AND TAXES ON PROFITS 

There are certain disputed items of accounting 
cost that probably should not be discussed in an eco- 
nomic treatise, but inasmuch as the economic prin- 
ciples announced in the foregoing pages may help to 
clarify their treatment, they are considered in this 
appendix. 

Discount on Sales 

When a corporation sells its product, it desires to 
receive as prompt payment as possible, and, there- 
fore, often offers a discount of two or three per cent 
on sales for cash or prompt payment. It is a much 
mooted question as to whether such cash discounts 
should be deducted from the Sales or added to Cost. 
Probably the accountant's first impulse is to treat 
such discounts as deductions from Sales. If a desk 
is sold for $100, but with a cash discount of two per 
cent, the buyer who pays promptly gets the desk for 
$98. The seller is willing to take a price of $98 from 
the cash buyer, just as he might make a lower price 
for any other type of preferred customer. Most 
accountants, however, do not classify such cash dis- 
counts as deductions from Sales but as financial 
expense for the reason that prompt payment enables 
them to borrow less capital. The discount, there- 

190 



DISPUTED ITEMS OF COST 191 

fore, is like an interest payment to the customer who 
furnishes capital by paying promptly. It may seem 
that it makes little difference how such an item is 
treated because the two methods result in the same 
profit. However, not only as a matter of theory, but 
also because cost should be defined definitely and 
consistently, there should be agreement as to the 
proper items to be included. If a buyer, for example, 
agrees to pay cost and a certain margin of profit, 
cost should be defined in unmistakable terms. 
Furthermore, when an accountant says cost, it 
should mean something definite and understandable. 
The entrepreneur has two types of business trans- 
actions, those with customers and those with the 
other factors of production or other entrepreneurs 
who help in his producing unit. Thus, he pays wages, 
rents, interest, and prices for raw materials, and 
he receives prices for his finished products. It 
might appear that the discount on sales is not a pay- 
ment or cost in the sense that it is paid to the factors 
of production. In so far as it is a payment, it is 
paid to customers; therefore, it might seem that it 
should not be considered in connection with cost but 
merely in connection with sales. There is an obvious 
answer to this, which the accountant might urge, 
namely, that the customer as prompt payer is not a 
customer but capitalist, and he receives his discount 
as capitalist and not as customer. Whether a cus- 
tomer who pays his bills promptly should be thought 
of as doing anything so unusual as to be called financ- 
ing is a question, but there is probably much to be 
said for it. 



192 ECONOMICS FOR THE ACCOUNTANT 

The second question to be considered is the fact 
that, if the discount is treated as a deduction from 
Sales, the price line of the price-cost curve may be 
affected. The price line of the diagram on page 
143 was shown as a straight line. If some of the 
buyers took their cash discounts and others did not, 
different companies might realize different average 
prices. In that event the price line would not be 
shown as a straight line, if the discounts were 
deducted from Sales. However, economic theory 
makes an unwarranted assumption when the price 
line is represented as a perfectly straight line. Pro- 
ducers do not always receive the same prices for the 
same commodity ; they may sell in different markets 
or under different conditions. Therefore, there could 
be no valid objection on this score to the deduction 
of discounts from Sales. Finally, if the assumptions 
of theory apply there is no reason why one seller 
would not have relatively the same amount of dis- 
count to pay as another. 

Probably the most important question in connec- 
tion with this problem is the possibility of including 
a charge for discount in cost. In constructing a unit 
cost before the Sales are consummated, there would 
be no way of knowing definitely what charge to allow 
for discounts. Some customers might take the dis- 
count whereas others would not. Thus, discounts 
are analogous to taxes on profits, which cannot be 
determined until Sales are consummated. They are 
dependent not only upon the size of the Sales, but 
also upon the promptness of payment after the Sales 
are consummated. This last consideration, more 



DISPUTED ITEMS OF COST 193 

than any other, should argue for the exclusion of dis- 
counts from cost and their deduction from Sales.^ 
The use of cost as a basis of price is only one of 
the purposes of cost accounting. The other purposes, 
set forth in the early chapters of this book and in 
Appendix I, namely, for measuring profit on dif- 
ferent lines after the product is sold, for the valua- 
tion of inventories, and for the analysis of itemized 
costs in order to effect economies represent uses of 
cost after the sales are consummated. For these 
purposes, the inclusion of Cash Discounts in cost 
would not be so objectionable, but since there is as 
much to be said for their deduction from Sales as 
for their inclusion in cost and since one of the prin- 
cipal purposes, if not the principal purpose, of cost 
accounting is the determination of a basis for future 
price, it seems best to exclude them entirely from 
accounting cost. In this connection it might be inter- 
esting to note that some accountants have argued 
against the inclusion of interest in cost for the same 
reason that has been given here, namely, that the 
interest is not determined until the sale is made. 
This confuses interest and profit ; interest is a charge 
the moment capital is invested and is not affected 
by sales.^ 

Bad Debts 

Very often in this imperfect world customers 
obtain goods but fail to pay for them. Whether the 
amount of such Bad Debts should be deducted from 

* See the definition of accounting cost, page 82. 
» See page 182. 



194 ECONOMICS FOR THE ACCOUNTANT 

Sales, included in cost, or treated as a deduction 
from realized profit is another one of the disputed 
problems of accounting, If a manufacturer sells 100 
desks at a price of $100, and receives payment for 
only 99 of them, he has sold 100 desks but has real- 
ized only $99 on each desk. It may be maintained, 
however, that he really sold 99 desks at an average 
price of $100 and that he practically gave away or 
lost one desk. If in manufacturing the desks one 
had been ruined, the production divisor would have 
been 99 instead of 100 and the cost would have been 
consequently greater. This may seem to argue for 
the inclusion of the Bad Debts in cost. In the last 
analysis, however, the same reasoning applies here 
that applied in the case of Cash Discounts. Bad 
Debts cannot be included in cost until after, and in 
many instances until long after, the sales are con- 
summated. Therefore, it seems desirable to deduct 
all the definitely known Bad Debts from Gross Sales 
in arriving at Net Sales, and to deduct the doubtful 
accounts from profit. 

OuTWAED Freight 

When a producer sells a commodity, he can sell it 
f . o. b. factory or delivered. If he sells it f. o. b. 
factory, the buyer pays all the freight charges 
between the factory and the destination required by 
the buyer. If the seller sells it delivered, he pays 
the freight. If the seller pays the freight, he will 
probably add it to the price he charges. 

In order to simplify the problem, it can be 
assumed, at first, that those goods sold delivered 



DISPUTED ITEMS OF COST 195 

have tlie actual freight paid on each shipment added 
to the price and that the goods sold f. o.b. factory 
include no freight. Then, if Outward Freight is 
deducted from Gross Sales, the Net Sales will give 
the prices actually paid for the commodity. However, 
the accountant may contend that the manufacturer 
is receiving different prices for the different units he 
is producing, and that these different prices are 
prices for the commodity and for freight. Thus, the 
manufacturer in Pittsburgh is selling steel to a buyer 
in Pittsburgh, steel and the freight to Baltimore to 
a buyer in Baltimore, steel and the freight to New 
York to a buyer in New York. Obviously if the 
accountant is computing a unit cost as the basis of 
selling price, he would have to have a different cost 
for the buyers in each city. Furthermore, in comput- 
ing cost before the sale was arranged, he would be 
unable to determine the Outward Freight until the 
destinations of the different units were determined. 
Thus, it seems desirable to make a general rule of 
deducting Outward Freight, as well as Cash Dis- 
counts and definitely known Bad Debts, from Gross 
Sales in order to arrive at Net Sales. In that event, 
the price line ^ would not be affected by the different 
freights. 

Donations 

The producer is often called upon to make dona- 
tions to charities, to the Red Cross, or to similar 
organizations. He usually considers such donations 
as a part of his cost. He argues that they are neces- 

*See page 143. 



196 ECONOMICS FOR THE ACCOUNTANT 

sary for the establishment of the goodwill of his 
business. 

If Donations are included in cost, the consumers 
pay them. It may be argued that consumers pay all 
the elements of price including profit. However, it 
should be realized that if Donations are included in 
cost, the consumer is really paying them for the 
entrepreneur, whose profit is not reduced and whose 
goodwill is established without any sacrifice. If a 
donation deserves the name, it should be given by 
the donor, that is, the entrepreneur, and it should 
reduce his profit. The same principle applies in the 
matter of the tax on profit. The Government 
definitely says that it will take a part of the entre- 
preneur's profit; if this tax could legally be added 
to cost, it would be paid by the consumer, not by the 
entrepreneur. Both taxes on profits and Donations 
represent divisions of profit and not items of account- 
ing cost. When prices are demoralized, hoAvever, the 
inclusion of these items in cost would not necessarily 
shift them to the consumer; in such times they would 
undoubtedly reduce profits or increase losses. How- 
ever, in normal times or in times of high prices, the 
accounting treatment of such items would help to 
determine who actually paid them. 

Tax on Profits 

There is an interesting question as to whether the 
accountant should include the tax on profits in cost. 
Obviously the bulk-line producer would have no such 
tax in his cost, because he would have none to pay. 



DISPUTED ITEMS OF COST 197 

Furthermore, the tax could not be included in cost 
when profit is being determined, because its inclu- 
sion would presuppose that profit was already 
determined; it is a tax based on profit. However, 
after it is determined, that is, after price is fixed, it 
might very well be added to the other costs or mone- 
tary sacrifices of the entrepreneur. But if the cost 
is to be used by the entrepreneur merely as a basis 
for fixing a price, it should not include the profit 
tax. Furthermore, in determining cost for the pur- 
pose of computing the profit tax to be paid, it would 
be absurd and logically impossible to attempt to 
include such a tax in cost. 



APPENDIX III 

QUESTIONS IN ECONOMICS FOB C. P. A. EXAMINATIONS 

It has come to be realized that the accountant 
must have some training in economics as a part of 
his equipment. In some States questions in eco- 
nomic theory and applied economics are given in 
the C. P. A. examinations. These questions are 
usually framed by economists, who have no knowl- 
edge of or interest in the kinds of questions the 
accountant should be expected to answer. Some of 
the questions asked, moreover, reflect the special 
interest of the economist who framed them. It would 
be unreasonable to expect the accountant to acquire 
complete information in all the fields of applied 
economics, such as money and banking, railroads, 
foreign exchange, etc. Yet, it is quite as unreason- 
able to give any accountant a C. P. A. certificate 
unless he grasps the fundamental principles of eco- 
nomic theory, on which the philosophy of account- 
ing is based. 

The following questions, which have been culled 
from C. P. A. examinations, are some of the better 
ones. 

The student can find suggestions for answers to tJie follow- 
ing questions in Chapter III: 

Discuss the motives in economic activity. (Wis., Nov., 
1919.) 

198 



C. p. A. QUESTIONS 199 

State what you mean by consumption, production, and 
distribution. (N. D., June, 1914.) 

Distinguish production and consumption. (N. D., 1919.) 

Define production, illustrating the several ways in which 
it can be affected. 

Define economic goods. How are economic goods dif- 
ferent from free goods? (Md., Dec, 1917.) 

Explain what is meant by the following: good; free 
good; capital goods; consumer's goods; production 
goods. (Wis., Nov., 1919.) 

Name and describe the factors of production. Differ- 
entiate between fixed and circulating capital.^ Give 
example. (Wis., April, 1914.) 

Distinguish fixed and circulating capital.^ (N. D., July, 
1919.) 

How does land differ from capital as an agency of 
production?^ (N. D., June, 1914.) 

Describe the process by which capital goods come into 
existence and are made available for productive 
use. (Wis., April, 1918.) 

Name and describe the factors of production. Classify 
the following under the respective factors of which 
they are examples: a newsboy, steam locomotive, 
coal deposits, pig iron, bookkeeper. State Official, 
pile-driver, draft horse, stock of shoes, insurance 
salesman. (Wis., April, 1918.) 

Are money-making and production identical? Explain. 
(Wis., Nov., 1919.) 

Define capital. Why is interest paid for capital ? (Md., 
Dec, 1917.) 



' Capital is probably used here in tbe sense of capital goods. See 
also Chapter XI. 



200 ECONOMICS FOR THE ACCOUNTANT 

The student can find suggestions for answers to tJie follow- 
ing questions in Chapter IV: 

On what basis would you allocate gross income to rent, 
wages, interest, and profits? That is, what is each 
economically entitled to? (Wis., Nov., 1919.) 

What fixes the market rate of wages? (N. D., Aug., 
1917.) 

If in a given country the laborers receive one-third 
of the annual income of the country, would an 
increase in the efficiency of the laborers increase 
the proportion received by the laborers? (Md., 
Dec, 1917.) 

What is pure interest, and what other elements enter 
into actual rates? ^ (N. D., Aug., 1917.) 

What effect does the invention of machinery have on 
the rate of interest? ^ (Md., Dec, 1917.) 

What is interest ? Why is it paid ? (N. D., June, 1914.)^ 

Discuss rent. (N. D., July, 1919.) 
The student can find suggestions for answers to the follow- 
ing questions in Chapter VI: 

What do you understand by demand? (N. D., July, 
1919.) 

What do you understand by the law of diminishing 
utility? (N.D., July, 1919.) 

State the law of diminishing utility and illustrate by 
a diagram and an explanation of the diagram. 
(Md., Dec, 1917.) 
The student can find suggestions for answers to the follow- 
ing questions in Chapter VII: 

Define money. What is the difference between "stand- 
ard of value ' ' and "medium of exchange * ' ? (Wis., 
April, 1918.) 

' See also Chapter XI and Chapter XII. 



C. p. A. QUESTIONS 201 

How does money act as a standard of value and what 

is the chief requirement of the substance used as 

such standard? (N. D., Aug., 1917.) 

What fixes the value of money? (N. D., Aug., 1917.) 

What is money? What is a standard dollar? (N. D., 

June, 1914.) 

It is argued that the United States should not burden 
future generations with additional Liberty Bond 
issues, but should adopt the simpler and cheaper 
expedient of issuing and using paper money in 
sufficient quantities to pay for the war. Would 
this be a good or poor policy? Why? (Wis., 
April, 1918.) 

The student can find suggestions for answers to tJie follow- 
ing questions in Chapter IX: 

Explain what is meant by fixed and variable expenses. 

(Wis., Nov., 1919.) 
Show the relation of fixed and variable expenses to unit 

cost of production. (Wis., Nov., 1919.) 

The student can find suggestions for answers to the follow- 
ing questions in Chapter XI/ 

Explain the relation between production, consumption, 
and prices, using the present-day industrial situa- 
tion in illustration. (Wis., Nov., 1919.)^ 

Explain how the price of a commodity is fixed under 
competitive conditions.^ (Md., Dec, 1917.) 

What are some of the principal factors entering into 
price determination? ^ (N. D., July, 1919.) 

Suppose the price of butter to be 40 cents per pound. 
Why has the price been fixed at that point, and 
under what conditions would it probably remain 

*See also Chapters V, VI, and VII. 



202 ECONOMICS FOR THE ACCOUNTANT 

at that point (assume normal conditions, and not 
war times) ? (Wis., April, 1918.)* 
Define profits. Is the payment on a bond a profit? 
(N. D., June, 1914.) 

The student can find suggestions for answers to tlie follow- 
ing questions in Chapter XIII: 

What is the law of diminishing returns as applied to 
extractive industries? (N. D., Aug., 1917.) 

What do you understand By monopoly? (N. D., July, 
1919.) 

Show how market prices are established in a free com- 
petitive market. Contrast this with the fixing of 
monopoly price. (Wis., April, 1914.) 

Indicate what effect the enforcement of the Sherman 
Anti-Trust law has had. (Wis., April, 1914.) 

State the nature of the Trust Problem before Congress 
and the country at the present time. (Wis., April, 
1914.) 

The student can find suggestions for an answer to the 
following question in Chapter XIV: 

Summarize strength and weakness of income tax. (N. 
D., July, 1919.) 

* See also Chapters V, VI, and VII. 



INDEX 



Accounting cost, 81 

Advertising, 63 

American Tobacco Company, 

163 
Anti-trust legislation, 162, 163 

Bad debts, 193 

Balance sheet, 8-12, 116-119, 

121-127, 131-135 
Banking, 52 

Bank of Amsterdam, 68 
Bank notes, 68, 69. 
Bargaining power, 37, 153 
Barter, 65 
Bastable, C. F., 166 
Bills payable, 130 
Bonds, 43, 117 
Bonus, 146 

Bulk-line cost, 148, 172 
Bureau of Markets, 154 
By-products, 94, 95, 96, 97, 98, 

99, 100, 101, 102, 103 

Capital, 24-26, 28, 30, 31, 43, 
85, 106, 107, 109, 113-135 

Capital goods, 23, 24, 27, 28, 31, 
37, 109, 119, 120, 121, 139 

Capitalists, 21, 30, 40, 42, 43, 
83, 137, 138 

Cash, 117 

Cash discounts, 190-193 

Cheeks, 69 

Clark, J. B., 36, 38 

Clayton Act, 163 

Collective bargaining, 154 



Combinations, 162, 163 
Commercial geography, 52 
Common stock, 27, 28, 131 
Competition, 39, 152-164 
Competitive system, 36 
Co-products, 94, 95, 96, 97, 98, 

99, 100, 101, 102, 103 
Consumers, 4, 50, 64 
Consumption, 18, 19, 47 
Consumption goods, 21, 25 
Control of corporation, 27, 28 
Corporations, 27 
Corporation finance, 53 
Cost, 7, 8, 15-17, 20, 33, 51, 54, 

55, 56, 60, 61, 62, 63, 77-85, 

147, 160, 161 
Cost of living theory of wages, 

39 
Cumulative preferred stock, 29 
Current expenses, 96 

Demand, 49, 54-63, 144 

Depletion, 85, 90 

Deposits, 68 

Depreciation, 80, 85, 87, 110- 

112, 180 
Dewing, A. S., 162 
Diminishing returns, 159 
Discounts, 68 
Distribution, 31, 34-46, 48 
Division of labor, 22, 31 
Donations, 195, 196 

Economics, 3, 47-50 
Economic goods, 20 



203 



204 



INDEX 



Economic proportion of fac- 
tors, 16 

Entrepreneur, 4, 21, 26-31, 45, 
81, 113, 136-140, 177 

Entrepreneur's cost, 81, 177 

Exchange, 32, 48 

Extensive cultivation, 159, 160 

Factors of production, 21 

Factory overhead, 87 

Federal Trade Commission, 155, 

156, 164 
Fixed investment, 86 
Fluidity of labor, capital, and 

land, 153 
Foreign exchange, 52 
Foreign trade, 52 
Form utilities, 19 
Free goods, 20 
Free trade, 4 

General and administrative ex- 
pense, 87 
Gold, 66, 67, 68 
Good, 18 

Goodwill, 124-128, 131 
Gross profit, 106, 150 

Hutcheson, Francis, 3 

Incidence of taxation, 169 
Income and excess profits tax, 

1, 170-173, 194, 196 
Increasing returns, 158, 159, 

160,161 
Industrial management, 52, 53 
Inheritance tax, 167 
Insurance, 52 
Intensive cultivation, 159 
Intercompany profit, 89 



Interdepartmental profit, 89 

Interest, 12, 29, 32, 43, 69, 74, 
86, 105, 106-108, 112, 113, 
121, 122, 123, 124, 125, 128, 
129, 130, 148, 174, 177-189 

Interest rate, 130 

Inventories, 117, 133, 134, 135, 
182 

Investment, 113, 127, 148 

Joint costs, 94, 95, 96, 97, 98, 
99, 100, 101, 102 

Labor, 52, 53, 87 
Labor organizations, 74 
Laborers, 4, 21, 48, 83 
Land, 22, 37, 86 
Landowners, 40 
Large-scale production, 157 
Legal tender, 26, 67 
Light, Heat, and Power, 85 
Limited liability, 27 
Luxuries, 58 

Maintenance and Repairs, 85 
Marginal cost, 143 
Marginal entrepreneur, 42 
Marginal laborer, 38 
Marginal land, 42 
Marginal utility, 56-63, 64 
Marketing, 34, 35 
Materials and Supplies, 85 
Medium of exchange, 26, 66 
Minimum of subsistence, 40 
Money, 25, 26, 32, 64-71, 80 
Monopoly, 161, 162, 163 
Mortgage bonds, 20 

Necessities, 57 
Notes payable, 130 



INDEX 



205 



Outward freight, 194, 195 
Overhead, 15, 16, 93 
Owners of land and capital 
goods, 21 

Paper money, 67, 68, 69 
Partnership, 27 
Patent, 157 
Place utilities, 19 
Political economy, 3 
Preferred stock, 29, 130, 137, 

138 
Price, 7, 32, 50, 54-62, 63, 69, 

72, 136, 147 
Price control, 155-157 
Price indices, 71, 72 
Prime costs, 157, 158 
Production, 18, 19-22, 47, 53, 

92 
Production goods, 21, 23 
Productive laborers, 20 
Productivity, 36-38, 49 
Productivity profit, 143, 144, 

146 
Profit, 7, 32, 33, 37, 45, 74, 122, 

123, 124, 125, 136, 137, 138, 

140-147 
Profit and Loss account, 5, 8, 

12-14. 
Profit sharing, 39, 146 
Protection, 4 

Quantity theory of money, 69, 

70 
Quesnay, 3 

Raw Materials, 15, 75, 84, 86, 

87-91 
Eaw-material cost, 88, 93, 94, 

95, 96, 97, 98, 99, 100, 101, 

102, 110, 157, 158 



Receivables, 117 

Rent, 32, 37, 41-43, 86, 90, 105, 

108-110 
Revaluation, 132 
Risk, 44, 140, 141, 142 
Royalty, 37 

Sacrifice cost, 77, 78, 79, 80, 178 
Salaries, 39, 112, 178, 180 
Sales, 5, 32 
Salesmanship, 62, 63. 
Secret rebating, 164 
Selling expense, 20, 87 
Service, 18 
Sherman Anti- Trust Law, 162, 

163 
Shifting taxes, 169 
Short-term notes, 127, 128, 130 
Single tax, 167-169 
Sinking-fund provisions, 29 
Specialization of function, 22 
Stabilization of prices, 75 
Standard of living theory of 

wages, 39, 40 
Standai'd Oil Company, 163 
Standard of value, 66 
Stewart, Sir James, 3 
Stocks, 117 
Stockholders, 125 
Stockholders' salaries, 107 
Super-marginal land, 43 
Supply, 51, 54, 55, 56, 60, 61, 

62, 63, 144 
Surplus, 117, 131 

Tariff, 169, 170 
Tax, 166, 167 
Taxation, 1 
Time utilities, 19 
Total utility, 59 



206 



INDEX 



Trade associations, 155, 156 
Transportation, 52 

Unfair competition, 161 
Unit cost, 74, 181, 182 

Valuation, 12, 119, 120 
Value in exchange, 56 



Value in use, 56 
Voting trust, 30 

Wages, 22, 32, 37, 38-41, 86, 91, 

158 
Walker, Francis, 45 
Wealth of Nations, 3 
Withers, Hartley, 69 



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